2002 - The Year of the Audit Committee

A quick glance at the newspapers any morning these days serves as an important reminder of the heightened scrutiny that all companies are under regarding the quality of their financial statements and related disclosures. Questions of “audit or independence” and board and audit committee “oversight” loom larger today than they did even last year when numerous new rules addressing these matters were first becoming effective.

We offer the following recommendations to assist boards in general, and audit committees in particular, in carrying out their duties this year:

Relationship with Independent Auditors

1.Review the audit firm’s independence. In addition to receiving the written disclosure statement from the outside auditors required by Independence Standards Board Standard No. 1 ¹, the audit committee should critically assess other facts and circumstances that could affect the independence of the outside auditors from management.

Performance of non-audit services

The provision of non-audit services by outside auditors is coming under increasing scrutiny. This issue was highlighted by changes last year in the proxy rules requiring companies to disclose the dollar value of audit and non-audit services and has taken on a new fervor this year in the aftermath of the Enron allegations.

Institutional investors and shareholder activists have responded to the proxy statement’s new metric for auditor independence – the ratio of audit fees to non-audit fees – in a number of ways. Some have adopted formulas to determine when they will vote against the ratification of auditors. Others examine the ratio in a more subjective light, taking into account any provided description of non-audit fees. Other shareholders are using the shareholder proposal process to pressure companies to limit the non-audit services provided by their independent auditors.

In addition, it seems likely that the SEC will propose additional regulations requiring greater separation of audit and non-audit services. These proposals may face less resistance from the accounting profession than in the past, due in part to the recent or planned spin-offs by several “Big 5” firms of their consulting businesses.

Given these developments, the audit committee should review the nature and amount of all non-audit work performed by the company’s outside auditors and consider any actual or perceived conflicts of interest that are posed by those services. Even companies concluding that a separation of current non-audit work is not needed to maintain auditor independence may wish to begin exploring possible alternative providers for non-audit work, in case a requirement to separate the work arises in the future.

Due to the way the SEC requires fees to be categorized, there are several items, such as tax services and services relating to public offerings, that must be reported as non-audit fees, but which do not raise the same level of concern as other non-audit services. In light of this, companies should consider adding to this year’s proxy statement a narrative explanation of what the non-audit services are and why the board does not believe they affect auditor independence.

Informal ties to management

The audit committee should know whether any of the company’s management or financial team were formerly employed by the outside auditors or have other relationships or ties to them. In addition, to minimize potential issues going forward, the committee should consider prohibiting the future employment of any partners or managers of the outside auditors who recently worked on the company’s audit.

2.Review your audit team’s qualifications. The committee should review the qualifications of the partners and senior managers providing audit services to the company. This review should include reviewing copies of their resumes and confirming with the accounting firm the current good standing of the audit team as CPAs, including their satisfaction of required continuing education requirements.

3.Reevaluate on an annual basis who the auditors should be. One of the audit committee’s most important jobs is to make an annual evaluation and selection of the company’s outside auditing firm. Although some have suggested that companies rotate their auditing firms on a periodic basis, there is no legal requirement to do so. There are, in fact, several legitimate reasons for maintaining a continuous relationship with the same firm, including the significant value of the knowledge that comes from a long-term relationship and the costs and inefficiencies that would result from frequently replacing firms. For example, under current SEC rules, it is necessary to continue obtaining consents from the former auditors or for the new auditors to re-audit past periods so they can issue their own report.
The annual review and selection of outside auditors should include a consideration of:

• satisfaction with the auditor’s performance, including how proactive the firm has been in identifying, raising and helping address potential issues relating to the company’s financial reporting;
• the auditing firm’s reputation and standing; and
• the auditing firm’s quality control programs and results of recent peer reviews.

This review is important regardless of which auditing firm the company is currently using.

4.Have an open door. The outside auditors should be encouraged to bring to the audit committee’s attention any concerns they have regarding the company’s accounting principles, financial statements or internal controls. Likewise, management should be encouraged to keep the audit committee informed of proposed changes in important accounting policies and of any potential accounting issues.

Quality of Financial Statements

5.Focus on critical accounting policies. The audit committee should review and discuss with management and the outside auditors the selection, application and disclosure of critical accounting policies – that is, those policies that are important to the portrayal of the company’s financial condition or results of operations and that require management’s most difficult, subjective or complex judgments. In addition, consideration should be given to those policies that would be most likely to result in material changes to the company’s financial condition or results if they were applied differently in future periods. Extra attention should be given to how and when any changes to accounting policies are disclosed.

In December 2001, the SEC issued specific “cautionary advice” on this topic and requested that companies discuss critical accounting policies as part of this year’s MD&A. More recently, in testimony to Congress, SEC Chairman Pitt said “audit committees must understand what and why critical accounting principles were chosen, how they were applied, and have a basis for believing the end result fairly presents their company's actual status."

Our December 2001 Corporate Advisor includes a more detailed discussion of the SEC’s guidance regarding the disclosure of critical accounting policies.

6. Carefully review “hot topics.” The audit committee should pay special attention to the financial statement treatment of:

• controversial areas – including off-balance sheet liabilities, use of “shell” companies, transactions with entities in which current or former officers or directors or other related parties have a financial interest, restructuring charges and significant non-restructuring write-downs and asset impairments;
• emerging areas – such as option repricings and accounting for intangibles; and
• areas that have reportedly been troublesome for other companies in the same or similar industry as the company.

Committee members may find it helpful to request from management, the outside auditors or counsel examples of “typical comments” issued by the SEC in these types of transactions. In addition, with respect to the disclosure of off-balance sheet liabilities, non-exchange traded contracts and related party transactions, committee members should consider the specific new guidance contained in the SEC’s January 22, 2002 statement on MD&A. This document, “Commission Statement about Management’s Discussion and Analysis of Financial Condition and Results of Operations (No. 33-8056; 34-45321)”, is available at the SEC’s website.

7.Focus on quality. In connection with the discussions required by Statement on Auditing Standards 61 ², the committee should inquire as to the quality of the company’s accounting judgments, not just the acceptability under GAAP of those judgments. The committee should have an understanding of whether the company’s choices are conservative, moderate or aggressive and help set a tone for how the company should approach its accounting.

8.Review quarterly results prior to earnings announcements. The company should review its quarterly results with the auditors and the audit committee prior to issuing the quarterly earnings press release. This is particularly important given the SEC’s recent “cautionary advice” and enforcement action regarding the reporting of pro forma financial information. Our December 2001 Corporate Advisor includes a detailed discussion of the SEC’s cautionary advice on pro forma financial information.

Composition and Functioning of the Audit Committee

9.Make sure the right people are on the audit committee. The NYSE, AMEX and Nasdaq all have requirements regarding the composition of audit committees, including standards for determining who is “independent” and requirements for financial literacy. The company should reconfirm, at least annually, that each member of the audit committee continues to meet all applicable requirements.

Moreover, the board should be aware of and consider any other relationships or connections that members of the audit committee may have with the company or management and which may create the impression of a lack of independence. As part of this process, the board should review the company’s policies and procedures for handling conflicts of interest.

10.Provide education opportunities for audit committee members. Even the most financially sophisticated member of the audit committee could benefit from an occasional tutorial from company management or the outside auditors on specifics of how the company accounts for its most important operations or on recent accounting developments. The rapid pace of change to accounting rules also points to a need for members of the audit committee to take advantage of continuing education programs. An increasing number of programs tailored to directors are being offered by universities, private vendors and corporate governance organizations. The goal of these educational programs is not to make the audit committee members into experts, but rather to help them better understand the important questions to ask.

11.Make the audit committee charter consistent with reality. All public companies are required to have a written audit committee charter and to review it every year. This annual review presents a good opportunity for the committee to confirm that it is doing everything the charter says it will do. To the extent the charter does not accurately reflect actual practice, the committee should determine whether or not a change to the charter is permissible (keeping in mind that much of what is typically included in the charter is legally mandated) or advisable.

12.Create a record of the audit committee’s deliberations. In order to establish that the committee has satisfied its duty of care, the committee should maintain minutes describing the issues considered by the committee, the process the committee used and the committee’s final determination of how to proceed. As is the case generally, the minutes should not read like a detailed transcript, but rather should document the committee’s consideration of relevant issues in a manner that demonstrates that the committee acted with due care.

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¹ Independence Standards Board Standard No. 1 requires auditors annually to disclose in writing all relationships that in the auditor’s professional opinion may reasonably be thought to bear on independence, confirm their perceived independence and engage in a discussion of independence.

² SAS 61 requires the company’s independent auditors to discuss with the audit committee, among other things, the following:

• methods to account for significant unusual transactions;
• the effect of significant accounting policies in controversial or emerging areas for which there is a lack of authoritative guidance or consensus;
• the process used by management in formulating particularly sensitive accounting estimates and the basis for the auditors’ conclusions regarding the reasonableness of those estimates; and
• disagreements with management over the application of accounting principles, the basis for management’s accounting estimates and the disclosures in the financial statements.

Jonathan Wolfman
[email protected]

Hal Leibowitz
[email protected]