Audit Committee Essentials

In response to the Sarbanes-Oxley Act, increased oversight burdens have been placed on boards of directors. Even the boards or trustees of many privately held and not-for-profit corporations have adopted a number of these practices as a measure of best corporate practice. The need has never been greater for audit committees to assume primary responsibility for some of the most important duties of the boards of directors and to report regularly to the full board. Providing indispensable and authoritative guidance, Audit Committee Essentials covers the roles and responsibilities of the audit committee and explains why risk management and internal control are so critical and how the audit committee can work to make them even more effective.

Avoiding complex jargon and legalese, this concise yet comprehensive volume emphasizes the oversight of the financial reporting process and related controls as well as the oversight of ethics and the independent and internal audits. Here, board members, audit committee members, and managers will find sound information about legally mandated matters affecting audit committees, as well as best practices advanced by thought leaders in the field of governance, with a focus on the requirements and responsibilities within the U.S.

Ideal for both profit and not-for-profit corporations, Audit Committee Essentials explains the essentials of the current status of audit committee formation requirements, operating guidelines, and specific respons-ibilities, including:

• The historical development of audit committees, from their earliest origins in the 1940s to the present

• Pertinent information from such highly respected legal sources as the Model Business Corporation Act, the Principles of Corporate Governance, and the 2007 edition of the Corporate Director’s Guidebook

• The personal characteristics of an effective board and audit committee member

• The specific duties of audit committees that are prescribed by law, regulation, or rule

• An overview of the audit committee duties that have emerged as best practices by means of reviews and analyses of corporate governance leaders and subject matter experts

• Legally required characteristics audit committees and their members should possess

• The critical importance to strong corporate governance of an ethical culture

Brimming with decision tables, checklists, and other valuable practice aids, Audit Committee Essentials provides a comprehen-sive overview of audit committee essentials in a concise and readable format.

Curtis C. Verschoor, CPA, author of eleven accounting books on audit committees and auditing, is the Chairman and CEO of C.C. Verschoor and Associates, Inc. He is an audit committee chair, researcher, consultant, and expert witness on assignments concerning corporate governance, corporate audit management, business, and professional ethics. He is a research professor of accounting at DePaul University and has been a CFO and a controller at several large corporations, including Baxter and Colgate-Palmolive. He has also published numerous journal articles on these subjects.

Audit Committee Essentials

By Curtis C. Verschoor

John Wiley & Sons

Copyright © 2008 Curtis C. Verschoor
All right reserved.
ISBN: 978-0-471-69959-0

Chapter One

Evolution of Audit Committees

Audit committees have had an important role in the governance of corporations since their inception in the early 1940s, and their visibility and contributions have greatly increased in the past few years. Audit committees have been described as organizations’ guardians of financial integrity. From a regulatory perspective, the governmental agency empowered to regulate the issuance and trading of securities of public corporations, the Securities and Exchange Commission (SEC), has been involved with the establishment and oversight of audit committees in public companies since their beginning years.

Interestingly, however, the stock exchanges, as self-regulatory agencies, have been directly involved in putting into place many of the detailed requirements that the SEC mandated that audit committees of public companies follow. A body of best practices beyond legal and regulatory requirements has also grown up as a result of the work of thought leaders from the legal, investment, and auditing professions.

The public accounting profession through the American Institute of Certified Public Accountants (AICPA) has also long actively supported the need for an important role for audit committees. Because of the increased emphasis placed on the governance of corporations in the postmillennium years, particularly those that are publicly held, audit committees in many not-for-profit organizations have become more prevalent and have received greater attention and visibility. Their influence in organizations has matched this trend.

EARLY EVENTS

The New York Stock Exchange (NYSE) suggested, and the SEC endorsed, the concept of audit committees composed of nonexecutive directors as early as 1940. At that time, the responsibilities envisioned for audit committees were quite narrow, basically being limited to the nomination of the external auditor and arranging some of the parameters of its engagement. The AICPA was also active in the discussion of the need for audit committees and in 1967 issued a policy statement recommending that public corporations establish audit committees composed of outside directors.

In 1974, the SEC required proxy statement disclosure of the existence and composition of audit committees in all public corporations where they were in place. The NYSE issued a white paper at approximately the same time that strongly recommended the formation of an audit committee by each company listed on that exchange.

Several important developments took place in the late 1970s. The AICPA Special Committee on Audit Committees renewed its earlier support for establishment of an audit committee composed entirely of independent directors. In early 1977, the NYSE enacted a listing requirement that all companies listed on that exchange appoint an audit committee of nonemployee or independent directors as a condition of continued listing on the exchange. The SEC was instrumental in bringing this initiative to fruition.

The NYSE clarified in 1978 its independence requirements for audit committee members. Audit committees had to consist solely of directors “independent of management and free from any relationship that would interfere with the exercise of independent judgment as a committee member.” At about the same time, the American Stock Exchange (ASE) also made a nonbinding recommendation that all of its listed companies should form independent audit committees. As noted later in this chapter, the National Association of Securities Dealers Automated Quotation System (Nasdaq) stock market established an audit committee requirement in 1989.

It should be borne in mind that in the 1970s, the influence of nonexecutive directors was substantially less than it has become in recent years. The idea that the major function of a board of directors is to represent the interests of shareowners was not prevalent. Thus, audit committee members were likely to be the only independent members of the board. In many cases, even total independence of the audit committee from management was more of a goal than an actuality.

An early endorsement by the legal profession of the concept of audit committees in public corporations appeared in the 1978 edition of the Corporate Director’s Guidebook published by the American Bar Association (ABA). Two years later, the ABA Committee on Corporate Laws published specific recommendations for the membership, responsibilities, and potential liabilities of audit committees and their director-members. Later chapters discuss the contents of subsequent versions of the Corporate Director’s Guidebook published by the ABA.

SEC REGULATORY, LEGAL, AND PRIVATE SECTOR INITIATIVES

The SEC continued its support for independent audit committees throughout the 1970s and sponsored public hearings related to corporate accountability and the adequacy of internal controls in U.S. corporations. The SEC stressed the “vital importance of an independent audit committee to the proper functioning of the corporation.”

According to the securities laws, the current definition of an audit committee is: a) A committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer: and

b) If no such committee exists with respect to an issuer, the entire board of directors of the issuer.

Several attempts in the late 1970s to require greater disclosure of internal control adequacy and audit committee performance failed to receive support from the business community and were withdrawn. The last and most sweeping attempt would have required management to assess and report publicly on the effectiveness of internal control systems and also management’s responses to internal control recommendations made by either internal or external auditors.

The formation in 1985 of the National Commission on Fraudulent Financial Reporting, also known as the Treadway Commission, after its chairman, resulted in renewed interest in audit committees on the part of financial statement users, preparers, auditors, legislators, regulators, and the general public. The Treadway report showed how audit committees could prevent or detect fraudulent financial reporting and contained 11 specific recommendations as to how this could be accomplished, including the recommendation concerning a management assessment of internal controls.

Appendix I to the Treadway report sets forth good practice guidelines for audit committees. These recommendations include the issues that audit committees should (1) be informed and vigilant, (2) have their duties and responsibilities set forth in a written charter, and (3) be given the resources and authority adequate to discharge their responsibilities. Additional guidance elsewhere in the Treadway report involves these recommendations that the audit committee should:

Not consist of fewer than three members

Include private meetings with the internal auditor and the external auditor

Report to full board

Require expanded knowledge of company operations

Include corporate and/or outside counsel in meetings

Possess knowledge of audit plans-of both external and internal auditor

Require knowledge of electronic data processing and review of security practices

Approve controls for use of other auditors in addition to principal auditor

Provide oversight of sensitive areas such as officers’ expenses and perquisites

Oversee any areas requiring special attention

Pursuant to Treadway recommendations, in 1989, the Nasdaq stock market required its listed companies to establish and maintain an audit committee of which the majority of members are independent directors.

After several years of deliberations, the American Law Institute, an organization consisting of judges, attorneys, and legal academics, adopted in 1992 but published in 1994 its Principles of Corporate Governance: Analysis and Recommendations. This two-volume work includes recommendations of the appropriate duties that should be undertaken by boards of directors and audit committees. The recommendations for duties of the board of directors as a whole are contained in Chapter 2 and those for audit committees are discussed in Chapter 4. Some of these recommendations became the basis of changes put into practice in later pronouncements of other statutes or recommended by other groups.

A Delaware Chancery Court decision, the in re Caremark International case in 1996, established the principle that

a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.

This decision is most important to audit committees as usually they oversee the organization’s information-gathering and dissemination functions, including relationships with internal and external auditors.

In 2003, the Delaware Supreme Court upheld the lower court’s articulation of a new duty of corporate directors in the in re The Walt Disney Company case. In this case, which involved whether the directors adequately considered the amount of compensation awarded to Michael Ovitz upon his discharge, was called the duty of good faith. The court held that directors who take an “ostrich-like approach” to corporate governance and “consciously and intentionally disregard their responsibilities, adopting a `we don’t care about the risks’ attitude” may be held liable for breaching their duty to act in good faith. The court specifically noted the importance of the duty of good faith, in addition to the duties of due care and of loyalty, as primary guidelines for legally evaluating the conduct of directors.

REGULATION ARISING FROM BANKING SCANDALS

A significant force in the development of audit committees resulted from the banking scandals of the late 1980s. A study of bank failures by the U.S. General Accounting Office (GAO) (now called the U.S. Government Accountability Office) showed that audit committees of even the largest banks were not sufficiently independent, lacked the expertise to accomplish their responsibilities, and did not receive assessments of key bank operations. The GAO recommended a strengthened role for audit committees in insured banks and savings institutions. Many of the GAO’s recommendations were enacted in December 1991 in the Federal Deposit Insurance Corporation Improvement Act (FDICIA). Under the act, the management of insured institutions are required to increase their activities that are designed to maintain effective internal controls over financial reporting, safeguarding assets, and compliance with relevant laws and regulations. Each year, the management of insured financial institutions must assess and issue a public report on the effectiveness of internal controls over financial reporting. The institution’s external auditor must provide an attestation opinion on management’s report. This requirement is the forerunner of a similar requirement contained in Sarbanes-Oxley. As a result of this increased emphasis, audit committees of insured institutions are also tasked to higher levels of oversight of the financial reporting, internal controls, and internal and external auditing of insured financial institutions.

STOCK EXCHANGE INITIATIVES

In late 1998, another landmark development affected audit committees. The SEC believed that the quality and related oversight of corporate financial reporting required a significant overall review and upgrade. Consequently, a Blue Ribbon Committee was formed by the New York Stock Exchange and the Nasdaq stock market. Using fast-track methods, the committee issued its report of 10 major recommendations in February 1999.

The Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (Blue Ribbon Committee Report) focused on the need for total independence and for financial literacy of all audit committee members and the benefits of a formal written charter for the audit committee. The report also included several best practices for audit committee relationships with the external audit firm and recommended specific interactions between the audit firm and the committee. The recommendations in the report were largely put into place as mandatory requirements by means of a series of SEC releases and stock exchange rules and through AICPA auditing standards that were issued later in 1999 and early 2000.

In the regulatory releases by the SEC and AICPA implementing the Blue Ribbon Committee Report, external auditors were directed to be primarily accountable to audit committees and provide them with information that would allow a candid discussion of the accounting judgments that were made by management and reflected in the financial statements. Also, management is required to provide more information to the audit committee regarding its evaluation of the company’s risk and control structure, together with supporting information concerning the contents of periodic financial statements.

Additional initiatives from the report led to four more requirements for public companies:

1. Proxy statements must include an annual report of audit committee activities.

2. Proxy statements must include the audit committee’s charter at least once every three years and more often if changes are made.

3. External auditors must be engaged to perform a formal current review of interim financial statements each quarter.

4. Proxy statements must include a breakdown of the total fees paid to external auditors for auditing, tax services, and other services.

The fee disclosure requirement exposed many examples (prior to 2002) where external auditors received fees for providing consulting services that some times approached or even exceeded what they received for auditing the corporation’s financial statements. Since the firms were well aware that providing consulting services to clients was much more profitable than the “commodity” of auditing financial statements, the large fees for nonaudit services tended to threaten the independence or at least the appearance of independence of external audit firms. The SEC felt very strongly that large consulting fees impaired the independence of external auditors. Public hearings were held, but at the time, the external audit firms successfully resisted any regulatory limits on the amount of consulting that could be provided to their audit clients.

SARBANES-OXLEY ACT OF 2002

The early years of the twenty-first century saw a number of accounting and auditing-related scandals, including Waste Management, Enron, HealthSouth, and WorldCom. These led to the passage of the Sarbanes-Oxley Act of 2002, portions of which are discussed at greater length in subsequent chapters. This legislation has been called the most significant change in the governance of publicly held corporations since passage of the securities laws of the mid-1930s. The major thrust of the legislation was to establish the Public Company Accounting Oversight Board (PCAOB) to regulate and monitor the practice of public accounting as it relates to publicly held companies. A major function of the PCAOB is to inspect the auditing and quality control practices of firms that audit publicly held companies.

Sarbanes-Oxley also took away from the AICPA, the trade or membership association of certified public accountants, the self-governance functions of public accountants, such as setting ethical, quality, and auditing standards and inspecting firms’ performance to assure their proper use. These functions are now provided by the PCAOB, an independent government agency under the oversight of the SEC. Sarbanes-Oxley Section 201(g) prohibits external auditors from performing certain services for their audit clients, including all internal auditing and almost all consulting. Sarbanes-Oxley Section 201(h) requires audit committee to approve in advance any taxation and other nonauditing services that external auditors provide to their audit clients.

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