Audit Committees in an Era of Increased Scrutiny

By Robert W. Rouse and Mark R. Borrelli

In Brief

More Important than Ever

Concern over the quality of public companies' financial reporting is nothing new. What has changed is the amount of attention that regulators give to audit
committees and their relationship with auditors, for both public and private companies.

In December 1999, the SEC issued new rules and amendments to existing rules designed to improve disclosures relating to audit committees. The self-regulatory organizations (SROs) have been keeping up with their own requirements and guidance that bring audit committees to center stage in terms of asking tough questions of management and auditors and being responsible for the answers.

Two issues have recently affected financial reporting of publicly held companies (registrants): earnings management and the changing responsibilities of the audit committee. While earnings management has generated more media attention, the sensitive role of the audit committee has produced many modifications in reporting requirements in both the public and private sectors.

Section 10A, which Congress added to the Securities and Exchange Act of 1934 as part of the Securities Litigation Reform Act of 1995, had an enormous impact on auditors. It introduced a requirement that auditors of public companies include procedures to detect illegal acts and report such acts that come to their attention to the registrant's management. But the amendment also highlighted the role expected of audit committees. Under Section 10A, upon discovering illegal activity, auditors not only must inform the registrant's management but also must ensure that the audit committee is aware of the activity. If the auditors determine that management has not taken appropriate remedial actions, they must then make a report to the board of directors. The board is then required to notify the SEC.

Piling on the Regulations

Regulators have been paying more attention to improper accounting practices recently. The SEC has amended its regulations for reporting within the financial statements (Regulation S-X) and required additional disclosures outside of them.

In addition, the Auditing Standards Board (ASB) has revised two Statements on Auditing Standards (SAS), and the various self-regulatory organizations (SROs)--Nasdaq, the American Stock Exchange, and the New York Stock Exchange--have modified their rules and definitions. In addition, the initial standard of the newly formed Independence Standards Board (ISB) addressed the relationship between the auditor and the audit committee.

Registrants need to be aware of all of these changes. The current composition of audit committees may have to change as a result of the regulations; in any event, an educational process for current audit committee members is almost certainly forthcoming.

How the SEC Sees the World

The SEC could have waved its magic wand and summarily issued decrees to effect these changes in its role as the legal designate for both GAAP and GAAS. While the SEC has long issued guidance relating to independence, historically it has preferred to look to the private sector to promulgate standards and to view itself as the standards setter of last resort. Congress has undoubtedly influenced the SEC's philosophy in this area, having strongly encouraged it to refrain from exercising its authority to modify standards unless the SEC believes that the private sector has either not responded or has responded inadequately.

In addition, the SEC lacks the resources to promulgate its own standards. Most of its staff members are attorneys, and the vast majority of the SEC's approximately 150 professional accountants work in the Division of Corporation Finance, which is charged with the review of filings. Approximately 25 accountants are in the Office of the Chief Accountant, and a like number in the Division of Enforcement.

The Commission looks to the ASB for GAAS, to FASB for GAAP, and to the newly created ISB for auditor independence standards. The SROs have specific rules that address independence and require audit committees, but the SEC has no such requirement.

The 1998 'Numbers Game' Speech

Many people trace the discussion of the need for increased responsibilities for audit committees back to the now famous "Numbers Game" speech that SEC Chair Arthur Levitt gave in September 1998 at the NYU Center for Law and Business.

The "Numbers Game" speech, however, had its roots in an earlier speech that Levitt made in March at Tulane University. In that speech, "Corporate Governance: Integrity in the Information Age," Levitt cited several enforcement actions in which corporate governance had failed. He then focused his attention on another group of directors that should be asking hard questions--the audit committee. He remarked, "These committees, in their special role, must help the board fulfill its oversight responsibilities in such areas as financial reporting and internal controls. They also are the primary link between the directors and the company's outside auditors."

When continuing this effort in the "Numbers Game," Levitt attacked earnings management. He spoke boldly of accounting "hocus-pocus," "big-bath" charges, creative acquisition accounting, "cookie jar" reserves, materiality, and revenue recognition and issued a call for "improved outside auditing in the financial reporting process" and "strengthening the audit committee process." He compared audit committees whose members lack expertise in financial reporting, meet only twice a year for 15 minutes, and have primarily perfunctory duties to those committees that meet 12 times a year, possess financial expertise and experience, are independent, and ask tough questions.

The Blue Ribbon Committee. Levitt also announced the creation of a Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. In early 1999, the Blue Ribbon Committee issued 10 recommendations. Two were aimed at strengthening audit committee independence. The committee suggested that SROs adopt more stringent rules for independence and that audit committees comprise only independent directors.

Three recommendations were aimed at making audit committees more effective. The Blue Ribbon Committee recommended that audit committees include at least three directors that are financially literate, adopt a formal written charter, and review its adequacy periodically. The committee also recommended that audit committees disclose in a registrant's proxy statement whether a formal written charter existed and whether the audit committee satisfied its responsibilities in compliance with the charter.

The Blue Ribbon Committee's remaining five recommendations were aimed at improving accountability:

* The audit committee should state that the outside auditor is ultimately accountable to the board and that it has the authority and responsibility to appoint the auditor.
* The listing rules of the SROs should require the audit committee to secure from the outside auditor a formal statement delineating all relationships, as required by ISB Standard No. 1.
* Auditors should be required to discuss with the audit committee the auditor's judgments about the quality, not just the acceptability, of the accounting principles incorporated in the registrant's financial reporting.
* A letter from the audit committee in the annual report and in Form 10-K should disclose whether management had reviewed the audited financial statements with the audit committee, whether the auditors had discussed with the audit committee the auditor's judgments and assessments affecting the financial statements, and whether the committee had discussed these issues internally and without management and the auditor.
* An outside auditor review of the registrant's interim financial reporting prior to the registrant's filing a 10-Q should be required. This engagement would be effected via a review, as discussed in the recently revised SAS No. 71, Interim Financial Information.

The New Standards

In January 1999, the ISB issued ISBS No. 1, Independence Discussions with Audit Committees, which required auditors of SEC registrants to disclose, at least annually and in writing, all relationships between the auditor and the registrant that may reasonably bear upon independence and to confirm the auditor's independence. Under this standard, the auditor must also meet with the audit committee to discuss the auditor's independence.

The ASB, the SROs, and the SEC have followed with new rules and requirements as well as modifications to existing regulations and definitions. The ASB recently issued SAS No. 90, Audit Committee Communications, which amends SAS No. 61, Communication with Audit Committees, and SAS No. 71, Interim Financial Information. SAS No. 90 adds a new paragraph to SAS No. 61 to reflect a Blue Ribbon recommendation requiring auditor discussion of the quality, not just the acceptability, of the registrant's application of GAAP in its financial reporting. SAS No. 90 requires that the discussion be open and frank and generally "include such matters as the consistency of the entity's accounting policies and their application, and the clarity and completeness of the financial statements, which include related disclosures."

Although the revised SAS No. 61 does require the auditor to address both the quality and acceptability of financial reporting principles, the changes in the auditing literature are not as comprehensive as envisioned by the Blue Ribbon Report. The recommendation called for the discussion of the aggressiveness or conservatism employed by the registrant in the application of GAAP.

The changes to SAS No. 61 also state that any items that have a significant impact upon the "representational faithfulness, verifiability, and neutrality of the accounting information" should be discussed. SAS No. 90 also amends SAS No. 71 to implement a Blue Ribbon recommendation that addresses the review engagement for registrants' interim financial statements. SAS No. 90 acknowledges that a review differs from an audit and does not provide assurance that the accountant would become aware of all matters affecting the accountant's judgments.

Under the revised SAS No. 71, the accountant should attempt to communicate with the audit committee on matters that have been identified during the review. The amendments to SAS No. 61 are effective for periods ending on or after December 15, 2000, and the amendments to SAS No. 71 are effective for interim periods ending on or after March 15, 2000.

The SROs now require listed companies to have a written charter for their audit committees, and the SROs have adopted more stringent and definitive definitions of an "independent director." Although each SRO has its unique definition of "independent director" and individual characteristics of the composition of the audit committee, in general, the SRO rules require that the audit committee comprise at least three independent directors, all of whom are able to read and understand financial statements. In exceptional or limited circumstances, one of the members may not be independent, but the corporation should explain the reasons for the lack of independence in the next annual proxy. Under the new SRO requirements, at least one of the members should have some financial sophistication, as demonstrated by oversight responsibilities, past experience, or professional certification.

Final Rules

In December 1999, the SEC issued new rules and amendments to existing rules designed to improve disclosures relating to audit committees.

The SEC amended Rule 10-01 of Regulation S-X, Interim Financial Statements, to require that an independent accountant review the financial information included in the Form 10-Q and Form 10-QSB prior to filing the reports. The SEC also extended the requirements of Item 302(a) of Regulation S-K, Supplementary Quarterly Financial Data, to a wider range of registrants. All registrants, except small business issuers filing on small business forms, are now required to meet the disclosure requirements of Item 302(a).

Newly created Item 306 of Regulation S-K, Audit Committee Report, and Item 7(e)(3) of Schedule 14A, Solicitation of Proxies, address the reports of audit committees now required in the proxy statements. In the report, each audit committee would state whether it had reviewed and discussed the audited financial statements with management, discussed with the independent auditors the matters required in revised SAS No. 61, and received from the auditor disclosures regarding the auditors' independence as required by ISBS No. 1.

Under Item 306, the report of the audit committee must state that the committee recommended to the board that the registrant's Form 10-K or Form 10-KSB include the audited financial statements. The registrant also must disclose in the proxy whether the board has adopted a written charter for the audit committee. If so, the registrant should include a copy of the charter in the proxy at least once every three years.

Advantages of Responsibility

The new requirements have accumulated very quickly, over about a year and a half. Given the coordinated efforts by the SEC, the SROs, the ISB, and the ASB to promulgate these requirements across the public and private sectors, a great deal of weight is being placed on the shoulders of audit committees. The spotlight is now on them to enhance the transparency of financial reporting. *

Robert W. Rouse is professor and chair of the department of accounting at the College of Charleston, Charleston, S.C.
Mark R. Borrelli is an attorney with Shefsky & Froelich Ltd. in Chicago, Ill., where he specializes in securities law, including the representation of public companies in connection with accounting issues. He was formerly an assistant regional director with the SEC in Chicago.

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