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July 1989

Oversight of the financial reporting process - part 1. (directions for establishing the financial reporting process) (part one of two)

by Waters, Robert K.

    Abstract- The National Commission on Fraudulent Financial Reporting has developed recommendations relating to the establishment of a committee responsible for oversight of the financial reporting process including a variety of recommended steps. The guidelines include: properly establishing a committee; selecting qualified members; and preparing for meetings.

HEADNOTE: The authors present directions for the establishment of this activity, including attention to suggestions for an audit committee coming from the report of the Treadway Commission. The article will help those responsible for oversight to clarify their roles and carry out their responsibilities. Part I, presented here, deals with the establishment of an oversight activity in the form of an audit committee, its charter, suggestions for meetings, and its role in the financial reporting process. The responsibilities of management in all types of business activities for financial reporting have never been greater than they are today. People involved in nearly every type of organized activity prepare and disseminate financial statements. Users of these statements are a broad category--not only investors but also regulatory bodies, creditors, customers, contributors and members of non-profit organizations, employees and, in many cases, the general public.

The expectations of users of financial statements, particularly the investor and regulatory authorities, have arisen significantly in the last decade. Attention has focused on those who perform oversight of the financial reporting process. This oversight function is shared in many entities by directors and trustees who are not part of management; in larger entities--and public companies in particular--by audit committees of the governing board; by independent auditors; and in some cases by internal auditors.

The National Commission on Fraudulent Financial Reporting (the Treadway Commission) focused attention on the role of audit committees in overseeing the financial reporting process and performing other duties. Companies listed on the New York Stock Exchange and those trading over-the-counter as National Market Systems Securities are required to have audit committees of the board of directors. In light of the emphasis on oversight of financial reporting, the authors believe that public companies not having such a committee should consider establishing one. While there is no general requirement for nonpublic companies or nonprofit organizations to have audit committees, many of them can also benefit from establishing one. In the absence of a committee, organizations can profit by identifying directors, or others not part of management, who can conduct oversight of financial reporting and auditing activity.

In recent years, the Auditing Standards Board (ASB) has given recognition to the oversight function as a feature of companies' internal controls. In April 1988, the ASB issued SAS No. 61, Communication with Audit Committees, which established a requirement for the auditor to determine that certain matters related to the audit are communicated to those responsible for oversight of the financial reporting process.

Audit committees offer important advantages to all organizations. The success of the oversight function, however, will depend on the resourcefulness and dedication of committee members and others responsible for this function, and the support and cooperation of the board and of management.

Effectiveness of an Audit Committee

To make sure a committee is as effective as possible, several steps can be taken including:

* Properly establishing the committee;

* Outlining its responsibilities;

* Selecting appropriate members;

* Familiarizing new members with their duties;

* Meeting with sufficient frequency;

* Preparing for meetings.

Establishing a Committee's Duties and Responsibilities

When forming a committee, factors such as applicable state laws, provisions of the company's corporate charter and its practice for establishing committees should be considered. Most committees are established either by a resolution of the board of directors or by an amendment to the bylaws. Other factors to consider include the committee's duties and responsibilities, the number of members, and the length of time, members may serve.

The committee should be large enough to represent a balance of views and experience, yet small enough to operate efficiently. Most committees have three to five members.

In determining the length of time committee members may serve, the board should weigh two opposing considerations: continuity and freshness. Rapid turnover can be detrimental to effectiveness since members need enough time to understand technical issues and committee operations. On the other hand, new members bring fresh viewpoints. As a balance, the board may establish staggered terms. Some committees have terms of one year with possible reappointment, while some have longer or open terms.

The Committee's Charter

The board should clearly define--and set down in writing--the committee's objectives, the range of its authority, the scope of its activities and its duties and responsibilities. Often this is done in a written charter, which provides the board, committee members, management, internal auditors and independent auditors with a clear understanding of the committee's role. The charter might also deal with the frequency of meetings and the composition of committee membership.

In developing a charter, the board should avoid unduly restricting the committee. The duties and responsibilities of the committee have to be flexible enough to allow it to operate effectively and yet provide some boundaries. The board should make certain that the charter responds to the company's needs; as those needs change, so should the charter.

Selecting Members

There are no specific skill requirements for members of the committee. In-depth business knowledge and familiarity with accounting practices and concepts are distinct advantages, although they are not prerequisites. Common sense and independent judgment are the most important qualifications.

Some companies question whether it is appropriate to have employees, (usually senior officers), serve on their audit committees. The rules of the New York Stock Exchange have long provided that all listed companies have audit committees composed solely of independent directors. The National Association of Securities Dealers (NASD) recently adopted a requirement stating that companies trading over-the-counter that qualify for designation as National Market Systems securities have audit committees with at least a majority of independent directors. The advantage of having outside directors is that they are in a better position to provide the independent point of view crucial to a committee's effectiveness.

Familiarizing New Members

To continue functioning effectively when membership changes, new committee members must become familiar with their responsibilities as soon as possible. See Figure 2 for a list of items that may be helpful to new members. New members may also find it useful to review the minutes of prior meetings and reports to the board, and to meet with, financial management. Briefings by the independent auditors and the internal auditors also could be beneficial.

Frequency and Content of Meetings

Audit committees do not have to meet frequently. Normally three or four meetings a year will suffice, with special meetings as necessary. However, the number of meetings is influenced by the committee's objectives and the scope of its activities. Committees usually schedule their meetings based on the company's business cycle, which often corresponds with major phases of the independent audit and with the internal audit schedule. It is usually more efficient if the committee meets immediately before board meetings.

Committees usually involve management, the internal auditors and the independent auditors in their meetings. They normally meet separately and privately with management, the chief internal auditor and the partner from the independent auditing firm in charge of the engagement, at convenient points during the year.

A written agenda should be prepared and distributed to committee members before meetings. Members should also receive minutes of the previous meeting, copies or a summary of recently completed internal audit reports and reports from the independent auditors on the scope and results of their work. Position papers on any matters being considered should also be made available. The committee should maintain minutes of each meeting.

The Financial Reporting Process

Financial reporting is a continuous process that provides management information and financial statements. To effectively review interim and annual financial statements, the committee must understand the company's business and industry, and the attendant risks. The committee should be satisfied that the key financial systems and the procedures and controls that support them will generate information necessary to manage and properly report on the operations of the company.

Information technology has a significant influence on financial reporting at most companies. The committee should be briefed on the extent to which the financial reporting system is automated and the controls are in place to ensure the generation of reliable information and to provide computer security. Internal auditors and independent auditors should describe the results of their testing of computerized systems and their assessment of controls over them. Figure 4 lists some questions the audit committee may ask when briefed on computerized financial systems.

The committee should be aware that the Foreign Corrupt Practices Act (FCPA) requires public companies to keep reasonably detailed records of all transactions and to maintain internal accounting controls that provide reasonable assurance that those transactions are properly authorized and recorded. Figure 1-4 omitted

(*)See also "Audit Committees for Governmental Units--How-To," by Patrick F. Hardiman, Alan Reinstein and David R. L. Gabhart; The CPA Journal, June 1986. (dagger)This article is adapted with permission from the monograph "Audit Commitee Guide" published and copyprighted by Coopers & Lybrand.

James S. Gerson, CPA, is a Partner and Director of Audit Policy in the National office of Coopers & Lybrand. Mr. Gerson is a member of the AICPA and the NYSSCPA. J. Robert Mooney, CPA, is a Partner in the Richmond, VA, office of Coopers & Lybrand. Mr. Mooney is a member of the AICPA and a member of the Virginia Society of CPAs. Donald F. Moran, CPA, is a Partner in the Detroit, MI, office of Coopers & Lybrand. Mr. Moran is a member of the AICPA and the Massachusetts and Michigan Societies of CPAs. Robert K. Waters, CPA, is a Partner in the Washington, DC, office of Coopers & Lybrand. Mr. Waters is a member of the AICPA and a member of the Minnesota Society of CPAs.

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