June 2003

Financial Literacy

By H. Stephen Grace, Jr., and John E. Haupert

Recent accounting scandals have energized Congress and the SEC to develop new laws and regulations aimed at strengthening corporate governance. While the intent of the myriad proposed changes is excellent, the devil will be in the details. The definition of financial literacy in particular will require great care because the Sarbanes-Oxley Act directs the SEC to define the term “financial expert” as it pertains to audit committee members. General guidelines for determining the financial sophistication of individuals already exist, and the exchanges stipulate that members of audit committees be financially literate. Apparently, however, the SEC will be strengthening the rules, because Sarbanes-Oxley specifies attributes that must be considered in crafting a new definition.

While this is an important effort, we hope the SEC will not set requirements that are too narrowly rigorous, because that could lead to an unwillingness to serve on audit committees and cause corporations to ignore literacy requirements too difficult to implement. The media coverage on the topic suggests that only individuals conversant with the technical aspects of GAAP accounting and other esoteric accounting principles will be considered financially literate. There is also a push to train prospective audit committee members in the financial reporting nuances of the corporation’s industry.

The SEC and others involved must recognize that a board’s primary responsibility is the understanding, approval, and oversight of the corporation’s strategic and operational aspects. The audit committee aids the board by overseeing the firm’s risk and control environment and monitoring the financial reporting process.

Effective oversight of a corporation’s risk and control environment requires skills well beyond an understanding of GAAP accounting. Monitoring cash flows, tracking capital expenditures, and following operational key value drivers are all part of this oversight, along with safeguarding internal controls from manipulation by senior management. Correctly done, this oversight helps ensure the integrity of the financial reporting process.

A board that wakes up on Thursday and finds the corporation cannot make payroll on Friday is financially illiterate, regardless of how much GAAP accounting expertise it possesses. Accordingly, the definition of financial literacy should focus on the characteristics that will enable an audit committee to help the board understand, approve, and oversee the actions of the corporation. The audit committee must have the financial literacy to ensure that the economic condition of the firm is understood by the board and accurately reflected in financial reports. For more arcane matters, be they legal, accounting, or otherwise, audit committees should retain specialists to advise them. Areas that might fall under financial literacy include the following:

Any other attributes to help define financial literacy that may be developed should focus on all the major issues, not only GAAP accounting. Then the new rules will help audit committees employ useful financial literacy.

H. Stephen Grace, Jr., PhD, is president of Grace & Co. Consultancy, Inc., and
John E. Haupert is a member of the board of advisors of Grace & Co. Prior to his retirement, Haupert was treasurer of the Port Authority of New York and New Jersey.

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