Audit Committees: The Solution to Quality Financial Reporting?

A 1999 Blue Ribbon Committee recommendation proposed that audit committees publicly express their belief that financial statements are fair and conform with generally accepted accounting principles (GAAP) in all material respects. Consequently, the Auditing Standards Board amended SAS 61 to require that an outside auditor discuss with the audit committee his judgment about the quality—not just acceptability—of the company’s accounting principles as applied in its financial reporting.

Recently, the SEC raised a concern about the current state of financial reporting oversight as provided by corporate audit committees, and adopted rules and standards that focus on their composition and activities. The SEC hopes these will improve financial reporting quality and discourage manipulation, believing that audit committees are best qualified to oversee the financial reporting process. SEC requirements echo those of SAS 61 and require a letter from the audit committee discussing both the quality of the applied accounting principles and a judgment on how they affect the company’s financial statements.

Sarbanes-Oxley gives audit committees greater responsibilities; they are now required to help prepare the audit, ratify the internal control system, and resolve disputes over accounting rules. Audit committees have now become another kind of auditor, with the right to get independent counsel and full payment from companies.

Setting standards for corporate governance through legislation (and penalties for noncompliance) does not bring management to a higher level of accountability; honesty and ethical behavior should be the central element in corporate governance. The presence of audit committees did not prevent the business failures of Enron, WorldCom, Adelphia Communications, and others.

Different groups define financial accounting quality in different ways. The Financial Analysts Federation (FAF), a branch of the Association for Investment Management and Research (AIMR), provides summary evaluations of disclosure practices for a sample of companies, based on their aggregate disclosure efforts over a fiscal year. Each year, about 400 to 500 companies are evaluated, based on various financial disclosures and statements, published information such as press releases and fact books, and direct disclosures to analysts. Analysts evaluate the timeliness, detail, and clarity of information presented.

FASB Concepts Statement 2, Qualitative Characteristics of Accounting Information, defined quality as a hierarchy of accounting qualities, with relevance and reliability considered the primary ones. In addition, the statement has a set of criteria, such as representational faithfulness, verifiability, neutrality, predictive value, feedback, comparability, consistency, and timeliness.

The 1994 AICPA Special Committee on Financial Reporting (the Jenkins Committee) did not refer to the “quality of financial reporting” but rather the “quality of reported earnings.” Its definition is not very instructive, and it appears that quality is related to both the ability to predict and the relevance of the information. In identifying quality, the Jenkins Committee used several concepts that emphasize users’ needs, such as understanding the nature of a company’s businesses and performance, changes affecting the company, management’s perspective, and others.

Standard and Poor’s considers accounting quality as a factor in establishing an industrial bond issue rating. Firms that consistently make timely and informative disclosures are considered less likely to withhold relevant unfavorable information.

Despite the lack of a standard definition, quality financial reporting must be the natural consequence of quality work performed by management, auditors, and accounting standards-setters.

High-quality accounting standards serve to deliver relevant, useful information to investors. The SEC requires that companies comply with initial and continuing disclosure obligations; the goal is to prevent misleading or incomplete financial reports and facilitate informed investment decisions. Quality is represented by the usefulness of financial information in making these decisions.

Former SEC Chair Arthur Levitt described accounting standards as the camera needed to photograph a company. Good standards, like good cameras, produce sharper, more accurate pictures. Weak standards, like bad cameras, are unreliable. Good photos are rare; most images are fuzzy and out of focus.

Levitt believes that capital markets’ success is directly dependent on the quality of the accounting and disclosure system. High-quality accounting standards produce financial statements that report events in the period in which they occur—not before and not after. There are no extra reserves, no deferral of loss recognition, and actual volatility is not smoothed away to create an artificial picture of steady and consistent growth. Quality is a transparency of financial reporting that represents the underlying business.

Developing high-quality standards is a long-term process. Yet given proper commitment, they result in greater investor confidence, which improves liquidity, reduces capital costs, and makes fair market prices possible. Their use should result in information neutrality; one survey shows that analysts prefer exact and certain information—despite limited relevance—over that which is inexact or uncertain.

Objectivity, accuracy, and fairness lead to credible information. An annual report’s credibility depends on the degree to which it is correct, complete, and objective. Disclosure and transparency are important elements of high-quality reporting. Corporate management has great latitude in its selection of accounting rules, interpretations, and allocation of revenues and costs. Earnings volatility has little or nothing to do with information quality, if investors and analysts know that management is following clear and appropriate accounting procedures.

One phenomenon that reduces the quality of financial reporting is a change in accounting standards, even if there are restatements; the ability to analyze trends over a long period is destroyed. In particular, consistency and comparability are not successful when the standard may be adopted in any of several years and allows a choice of how to adopt, such as retroactive or prospective application. When a new standard is issued to replace an old one, the new standard should simplify adoption procedures and make it effective for all entities in a single year, under one method. New standards should improve comparability, consistency, and understandability, not only relevance and reliability. The accounting profession must improve its reports to the public, and standards must clearly reflect the economics of the underlying transactions.

High-quality accounting standards should not need abundant rules and regulations that add up year after year. Every new regulation that specifies how to account for a transaction brings an opportunity to find a way around it by creating a more complex transaction. This, in turn, creates the need for a new rule to tighten the loophole, and so on.

The audit committee’s role, as described by the SEC, the NYSE, and the NASD, is that of a watchdog; the role of an outside auditor is that of a corporate watchdog. Do companies need two watchdogs? Audit committees depend on a company’s management and outside auditor for a full range of information, based on both fact and judgment, on the financial reporting process. Committee members are members of the board of directors. Directors are selected by company executives and voted by shareholders. Most shareholders do not know the nominated directors and approve management’s selections.

Poor-quality financial reporting can result from the failure of an audit committee to question management’s selection of accounting methods. An audit committee is neither intended nor equipped to guarantee to the board of directors and shareholders the accuracy and quality of a company’s financial statements and accounting practices. The committee has no time to watch for the details in financial reporting, nor to design and implement a strong internal control system to prevent poor reporting.

Furthermore, an audit committee has neither the time nor the technical expertise to examine “appropriate” accounting principles. The members also have no power to oversee senior executives’ teams, nor to argue with them. Directors often have close relationships with corporate executives; they populate each other’s boards and tend not to criticize each other. Because of these factors, using audit committees as a tool for corporate governance has not been proven effective.

The Sarbanes-Oxley Act requires CEOs and CFOs to certify their quarterly and annual reports filed with the SEC. They must state that the reports fairly present the firm’s financial condition and operations, and do not omit material information. As a result, three entities—corporate executives, outside auditors, and audit committees—now certify financial statements. This increases companies’ costs, divides responsibility among parties, and takes the control for providing quality financial reporting out of everyone’s hands. Who is responsible in case of fraud? Who is in charge if something goes wrong? Improving corporate governance requires someone to be responsible, to be ethical, and to work for the benefit of stakeholders.

The author surveyed audit committee members at 50 NYSE companies, and found that most depend upon management and outside auditors for information. They do not think that financial reporting is poor quality until something goes wrong and is discovered by outsiders, with bad news in the press. If this doesn’t occur, the issue of financial reporting quality was not discussed by audit committees.

The survey showed that audit committees’ main concern is that even with their best efforts, they cannot prevent fraudulent financial reporting if management overrides internal controls and GAAP.

The internal audit function is an active participant in the process of corporate governance, as outlined in the Sarbanes-Oxley Act. Effective governance starts from inside the company and not from outside. The internal auditor is the most important partner in effective corporate governance and improving the quality of financial reporting, having the time to examine every financial reporting detail.

Discretion and subjective judgment have an impact on the quality of financial reporting; management needs to make sound financial judgments. Audit committees do not replace this need. Both external and internal auditors must evaluate those judgments. High-quality financial reporting can only result from effective relationships between corporate boards, internal and external auditors, and standards setters. They must work together to produce the high-quality financial reporting that capital markets require.

Independence is the cornerstone of accountability. The main problem is that corporate management hires, fires, and pays both their internal and external auditors. Auditors develop good relationships with management to keep the job or the client. They are not independent from corporate management. Even though the Sarbanes-Oxley Act prevents auditors from providing nonaudit service to audit clients, auditors will understandably want to keep clients as long as possible.

The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB). The act has a list of information about PCAOB registration, retention requirement, annual inspections, investigations, and violations. Funding for the PCAOB and FASB will come from annual support fees from accounting firms. Despite these precautions, this does not ensure auditors’ independence from management.

To have independent internal and external auditors, a third party, such as the PCAOB, should hire, fire, and pay internal and external auditors. The PCAOB should also collect mandatory fees from all public companies to pay the auditors. The amount can be determined as a percentage of a company’s revenues, assets, or income. In this case, internal as well as external auditors are independent from the management of companies they audit.

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