Shaping the audit committee agenda
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Shaping the Audit Committee Agendan audit committee is created by a company’s board of directors andplays a crucial role in the corporate governance process, a processAthat is the cornerstone of shareholder protection. This view wasconfirmed in September 1998 by the New York Stock Exchange and theNational Association of Securities Dealers, which sponsored, at the SEC’srequest, a “blue ribbon” committee to develop a series of far-rangingrecommendations to empower audit committees to function, on behalf of theboard, as the ultimate guardian of investor interests and corporateaccountability. The committee issued its report in February 1999. Effectivecorporate governance, however, must include the active and collaborativeparticipation of all of its principal champions — the audit committee, boardof directors, independent auditors, internal auditors, and management.Ensuring that this occurs is fundamental to the audit committee’s success.The audit committee must be independent of management. Its functions andresponsibilities, which are approved by the board of directors, will vary fromcompany to company. But the essence of each committee’s objectives isassessing the company’s processes relating to its risks and controlenvironment, overseeing financial reporting, and evaluating internal andindependent audit processes. And since an audit committee shares many ofthe same objectives as the company’s independent auditors, a close workingrelationship ...
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“Effective oversight of the financial reporting process depends to a very large extent on strong audit committees. Qualified, committed, independent, and tough minded audit committees represent the most reliable guardians of the public interest . . . this is a time for . bold actio”n Arthur Levitt — Chairman, Securities and Exchange Commission (February 8, 1999)
Shaping the Audit Committee Agend
Current and Emerging Issues 1 Risk Indicators . . . . . . . . . . . . . . . . . . . . . . .2 The Blue Ribbon Committee . . . . . . . . . . . . .4 Earnings Management . . . . . . . . . . . . . . . . . .6 Year 2000 . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Directors’Liability . . . . . . . . . . . . . . . . . . . .9 Complex Corporate Structures . . . . . . . . . . .10 Economic and Monetary Union . . . . . . . . . .11 Enterprise Package Solutions . . . . . . . . . . . .12 Emerging Companies . . . . . . . . . . . . . . . . . .13 Specialized and Regulated Industries . . . . . . . . . . . . . . . . . . . . . . . . . .14
Audit Commitee Responsibilities 15 Assessing the Processes Related to the Company’s Risks and Control Environment . . . . . . . . .18 Overseeing Financial Reporting . . . . . . . . . . . . . . . . . . .21 Evaluating the Internal and Independent Audit Processes . . . . . . . . . . . . . . . . . . . . .25
Creating an Ef 31 Committeeective Audit Charter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Committee Independence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Committee Membership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Member Skills and Training . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Reviews and Briefings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Committee Meetings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Committee Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Members’Compensation and Benefits. . . . . . . . . . . . . . . . . . . . . . . 40 Self-Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Appendices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43
KPMG Offices in the United States. . . . . . .69. . . . . . . . . .
Current and Emerging Issues
The need to address current and emerging issues is a fundamental requirement for effective management because the issues can have a direct or indirect impact on a company’s control environment, financial reporting, and the audit process. Assessing how the organization responds to the challenge is at the core of an audit committee’sCurrent and Emerging Issues responsibility. An auditShaping the Audit Committee Agenda committee must be mindful of ”Is the audit committee contributing to a “no surpris es what is happening within a the audit committee alert to the indicatorsenvironment? Is company now and, at the samecontributing to the company’s risk profile? time, what may happen in theIs timttc modutieha to tond lue he baeydeer erpst oenmmcores?ontidaocnobbir eettimmommittee truly sIt eha dutic future. In today’s globalindependent and its members financially literate? Are the economy and formidableepdnniedsaH ?”tnednepedin “rstodiaut ens fuifictteeebneit commi the audr ylropeup ocilbgeli tnttlendiy si ti tlpmoc niwie nciath business environment, beingits charter? prepared — staying ahead of theEC Sano tndpoesae otni yriuqni gsrninsIgamem narepoent g oprtintaresnoi ni er aonspblsiwae Cy?uodlht eocpmna ysatisfactorily r curve — is a major ingredientmanagement? for success.Will your company be able to operate as usual on January 1, 2000? Is management prioritizingY eitasr 200 efort to address mission-critical systems? Are backup plans in place? Audit committee members do therebAre you fulfilling your responsibilities as a director andy not need a crystal ball to bemitigating your potential liability? aware of the many businessr eldnahahc dipapeom clyo tntte tusmeneeitnffhctianagIs mtsme sek sna dsegnni e issues that promise to influencenortdnc sea ecsslyuateadeqols org s’ynapmocro phe tDo h?wtysce with eping pai ehsudnton coltry?trre A a company’s future and thus thesuity and internatoian lerca?horpptht ore nigaitazs’nomoc xelp committee’s work. There areUnioary fectn afbrsuy uo?sH niseur Ehe tEcn eaopa cimonotenoM dniWllundeand ted alua tvemenenagasam eht dootsr risk indicators that can provideimplications of the euro? the committee with valuableHave the control implications for enterprise-wide solutions been de dressed?vHeaco information about those stressen wystsme?sintroduction of quay adatelrht decneht hguo blsronthaenn ee points that may, if not addressedIs a dominant entrepreneur or manager adequately controlled? or monitored, lead to adverseDoes the audit committee tailor its responsibilities to reflect consequences. While the issues,s?enemaganesdradt icepsdesudni cif regstryionsulatr qea dnemtniuerpesficiyrc nois cniudtss? Has mderation including their nature and relative importance, vary by company, we believe that the current and emerging issues in the box should, at a minimum, be on every audit committee’s radar screen.
Risk Indicators
Is the audit committee contributing to a “no surprises” environment? Is the audit committee alert to the indicators contributing to the company’s risk profile?
The environment in which an organization operates can have a direct impact on the way a company is managed. By understanding the environment and the pressures the organization and its management are facing, the audit committee can assure itself that risks are being identified and, most important, being mitigated. Such an approach enables the committee to exercise its responsibilities in an active rather than a reactive manner, and minimize “surprises.”
What influences the company’s environment?Every company is different and will be subject to its own risks, but the risks will be driven by a number of basic factors. The interaction of many elements — the organization’s control environment; its management’s capabilities; its industry, market conditions, and expectations; its operating and financial stability; and the nature of its assets — all will contribute to a unique risk profile. This profile directly affects the audit committee’s core responsibilities — assessing the company’s processes relating to its risks and control environment, overseeing its financial reporting, and evaluating its internal and independent audit processes.
What are the indicators to look for?Some examples are contained in the box to the right.
To facilitate identifying risk indicators, the company’s senior executives should meet regularly with the audit committee to keep it informed of the risks and exposures facing the company. In addition, the committee should be briefed on the company’s strategic objectives, procedures for achieving them, and evaluations of the progress toward meeting them. Such meetings will often be at the full board level; however, where appropriate, we encourage audit committees to request additional meetings to address issues outside the purview of the full board or to obtain a more detailed understanding. The committee should also seek the observations of the internal and independent auditors, and draw upon its members’own business acumen.
n n n n n n n n n n n n n n n n n n n n
Risk Indicators
Inappropriate “tone at the ”top. Unrealistic earnings expectations by the financial coym.munit Unrealistic growth goals. Ongoing or prior vienstigations by regulators or others. Overly complex organizational structures or transactions. Frequent organizational changes. High turnvoer of senior management. Lack of succession plans. Inexperienced management. Unusually rapid growth. Inappropriate focus on the importance of maintaining trends and achieving forecasts. Lack of managementv eorsight. Management voerride. Autocratic management. Untimely reporting and responses to audit committee inquiries. Excessive or inappropriate performance-based compensation. Exposure to rapid technological changes. Industry“softness” or downturns. Interest rate and currency exposures. Unusual results or trends.
The Blue Ribbon Committee Is the audit committee ready to respond to the blue ribbon committee recommendations? Is the audit committee truly independent and its members financially literate? Are the independent auditors “independent”? Has the audit committee been sufficiently diligent to publicly report it is in compliance with its charter?
In the autumn of 1998, SEC Chairman Arthur Levitt announced the formation of a blue ribbon committee charged with developing a series of recommendations to enable audit committees to function as the “ultimate guardian of investor interests and corporate accountability.” Officially called the “Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees,” the committee was sponsored jointly by the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD). Its eleven members contributed a diversity of experience associated with self-regulatory organizations as well as the corporate community, investors, independent auditors, securities firms, and the legal community. The committee solicited public comments and held a public hearing in its quest to develop recommendations that would best help audit committees carry out their responsibilities. The committee’s recommendations, along with a number of guidelines for best practices for audit committees, were announced in February 1999.
The recommendations are designed to improve financial reporting and focus on the oversight function where discretion and subjective judgments bear on the quality of financial reporting. There are ten recommendations in all.
The first two are aimed at strengthening the audit committee’s independence. Citing studies suggesting a correlation between audit committee independence and both a higher degree of oversight and a lower incidence of financial statement fraud, the blue ribbon committee would have each member be an independent director, as defined in its report. An audit committee member without material ties of any kind to management, as the report points out, is more likely to be objective in evaluating the propriety of a company’s accounting, internal control, and reporting practices. Some exceptions would be granted.
Recommendations 3, 4, and 5 are concerned with making the audit committee more effective. Members would be financially literate, ideally with prior finance or accounting experience. There would be a formal written charter, approved by the board, defining the committee’s role, responsibilities, structure, and processes. Careful attention would be paid to the scope of the committee’s oversight responsibilities. Information about the charter would be disclosed in a company’s proxy statement or annual report.
The final five recommendations deal with mechanisms for accountability among the audit committee, independent auditor, and management. Recognizing the board of directors as representatives of shareholders, the blue ribbon committee would have the auditor be ultimately accountable to the audit committee and the board. The independent auditor would communicate to the committee those relationships with the company that bear on independence. Further, the auditor would discuss with the committee the quality of the accounting principles used in the company’s financial reporting. A report from the audit committee stating that — based on its discussions with the independent auditors and management — the committee believes that the company’s financial statements are fairly presented in conformity with generally accepted accounting principles would be included in a company’s annual report. In recognition of the importance of interim reporting to a company’s market performance, interim financial reviews involving the independent auditor and the audit committee would be required. The recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees are discussed in later sections. The full text can be found in Appendix I.
The blue ribbon committee hopes that its recommendations will effect “pragmatic, progressive changes in the functions and expectations of corporate boards, audit committees, and auditors regarding financial reporting and the oversight process.” To facilitate the change, the committee believes that the recommendations should be incorporated into SEC disclosure rules, exchange listing requirements, and generally accepted auditing standards. Changes to rules and regulations will not, of course, occur overnight. In fact, in many cases the changes will require public exposure and comment.
How then should an audit committee react?The blue ribbon committee’s recommendations are based on the premise that an audit committee has a professional approach to the discharge of its responsibilities. Therefore, we believe that a committee should not wait for a regulator’s “rubber stamp” before considering and acting on the recommendations. Some do not lend themselves to early adoption, but a committee can “adopt” their spirit before a mandated change. To this end we encourage an audit committee to act now — implement the recommendations it can readily handle and position itself to comply with others before implementation is required.
Earnings Management Is management reporting operations in a responsible way? Could the company satisfactorily respond to an SEC inquiry into earnings management?
A number of recent high-profile irregularities reported in the press have been attributed to various earnings management practices. These include questionable revenue recognition and gain recognition; inappropriate deferral of expenses; and incorrect recognition, reversal, or use of reserves without events or circumstances to justify such actions. These practices have piqued the interest of the SEC and others in a company’s accounting policies and procedures and have led to questions about the quality of reported earnings.
The pressure to achieve earnings targets can place a heavy burden on senior management, in terms of both job security and remuneration. Unfortunately, this can all too often lead to the consideration of aggressive and sometimes incorrect financial reporting interpretations. Given the complexity of certain transactions and the subjectivity of various accounting measures, we believe it is imperative that the audit committee fully understand a company’s accounting policies and procedures.
Specifically the audit committee should understand significant and unusual transactions, revenue recognition practices, and significant deferred costs, accruals, and management estimates. Often, management will justify its accounting by arguing that it is conservative or matches revenue and costs. Much of the SEC’s concern stems from just these views, and the commission often challenges companies for recognizing either “too much, too soon” or “too little, too late.” The SEC’s current emphasis is on recognizing items in the balance sheet when, and only when, they meet the definition of an asset or liability — and not, in the words of a former SEC chief accountant, on the “dangerous idea” of the matching principle, a principle that enjoyed prominence and acceptability not long ago. The audit committee must not only understand the appropriateness and application of these fundamental accounting concepts but may also have to challenge management on their application. Certain of these concepts may require a paradigm shift from past to current practice.
There is a fine line between unacceptable earnings management and outright fraudulent financial reporting.When does a company step over that line?As the SEC heightens its focus on this issue, the risk will increase to those companies that, in the opinion of the SEC, are operating in the “gray area between legitimacy and outright fraud. . . where earnings reports reflect the desires of management rather than the underlying financial performance of the company.” We can expect further accounting and disclosure guidance and other initiatives directed at this concern.
The SEC staff has been instructed to “root out and aggressively act on abuses of the financial reporting process.” Programs have been implemented to target reviews of companies that announce restructuring activity, major write-offs, or significant charges or practices, some that appear to be designed to manage current or future earnings. The SEC expects that management will have discussed such matters with the audit committee. The SEC’s reaction has already been felt by several companies; some of the companies have even been subject to enforcement proceedings.
Earnings Management — the SEC View SEC Chairman ArthurevLitt recently identified five areas of accounting “hocus-pocus” that in the SEC’s view obscure financial volatility and adversely afefct the quality of reported earnings. n“Big Bath” Charges.One-time restructuring charges are discounted by analysts and vienstors who focus on future earnings. vBeyr sotating these restructuring charges companies create v“reess” etrhat are used to offset future operating costs. nCreative AcquisitionAccounting.The use of “merger mag”ic, avoiding future earnings charges throuxcgeh sesive one-time charges for in-process research andv edleopment and the creation oxcf eessive purchase accounting revsesr. nMiscellaneous “Cookie Jar”Reserves.The use of unrealistic or overly “consevrative” assumptions when establishing revesse rin the “good times” and using these to shore up earnings in the “ba”d times. nAbuse of the Materiality Concept.The intentional recording of errors under the assertion that their impact on the bottom line is not significant; hwoever, given the market’s reaction to small changes in earnings per share, what is significant and what is not? nRevenue Recognition.Recognizing rvenue before a sale is complete, before the product has been delivered, or while the customer can still cancel the sale.
How should audit committee members respond?They must fulfill their fiduciary responsibility; they should understand the company; they should be briefed and stay up-to-date; they must ask insightful questions; and they must be active participants in the oversight function. The blue ribbon committee’s recommendations and guiding principles for best practices for improving the effectiveness of corporate audit committees are directives that can assist the audit committee in designing its response.
