Audit Committee Members: the Act Affects You!

The recent and seemingly endless series of high-profile corporate scandals and failures has caused the investing public and regulatory authorities to become increasingly concerned about corporate governance and financial disclosure. The congressional response to this concern, the Sarbanes-Oxley Act of 2002 (the Act) contains, among many other provisions, significant enhancements to the responsibilities of audit committees. As a result of the Act, audit committees can no longer be rubber-stamping “yes-men” in corporate governance. They must now meet specific qualifications of financial literacy and independence, and exercise reasonable diligence and good faith judgment in the monitoring of management, and internal and external auditors. If they do not, they could subject the company and themselves to shareholder lawsuits and the company to SEC actions and/or being de-listed by their respective exchange. The provisions of the Act that directly affect audit committees are presented by title and section and discussed further below:

Title II: Auditor Independence

• Section 201. Services outside the scope of practice of auditors. This section prohibits registered public accounting firms from auditing a company and performing specifically identified services for the same company. Public accounting firms, large and small, have, over time, been entrepreneurial in expanding the number of highly profitable non-audit and non-traditional tax advisory services (ie, financial information systems design and implementation, appraisal, expert services, etc.). Recently, in recognition of increasing independence requirements, some firms have sold or discontinued selected advisory services practices (ie, PricewaterhouseCoopers sold its financial information system and implementation practice to IBM in 2001 and KPMG sold its litigation consulting services practice to FTI Consulting in 2003). However, most firms have retained some or all of their advisory services practices. In light of public accounting firms continuing to offer both audit and prohibited non-audit services, audit committees should be diligent in confirming that 1) the company's auditor has communicated or otherwise made readily available to partners and practice groups the names of all audit clients and their subsidiaries; 2) the scope of approved non-audit services does not “creep” into a prohibited non-audit service; and 3) the standards of independence are not violated.
• Section 202. Pre-approval requirements. All auditing and non-auditing services shall be pre-approved by the company's audit committee except if the non-audit services are less than 5% of the total amount of fees paid by the company to the auditor during the fiscal year in which the services were performed. Additionally, approval of non-audit services must be disclosed. Audit committees should insist that the company's auditor agree to a budgeted and/or predetermined fee or prepare detailed work plans and budgets to accompany all proposals for non-audit services, and be required to adhere to the budget and immediately communicate any changes in scope, additions to the work plan, or increases in fees to management and/or the audit committee so that the 5% threshold can be re-evaluated, approved and disclosed, if necessary. Preliminary or initial budgets can quickly change based on the nature of the work or the degree of “added value” initiative pursued by the non-audit engagement team.
• Section 203. Audit partner rotation. The lead audit partner and the audit partner responsible for reviewing the audit must rotate off the engagement every 5 years. There are several positive aspects and several negative aspects to this provision. Positive aspects include: 1) the existing audit partner is aware that there will be a check and balance on his or her opinions, and thereby, may be more diligent in critically identifying and approaching audit issues; 2) the introduction of a new audit partner could provide a fresh look at audit issues and internal control reviews and, thereby, identify matters that would not have been previously identified; and 3) diminishing the possibility of misdeeds by management as the introduction of a new audit partner may result in eliminating auditing “loopholes” found and exploited by management. Some of the negative aspects include, but may not be limited to: 1) the loss of 5 years (or more after the first rotation) of knowledge and experience related to the operations (often complex) and internal controls of the company; 2) in smaller firms, the audit partner most knowledgeable about the industry may be the partner rotating off the engagement (in situations such as this, the company may need to consider evaluating the experience of partners in other firms); and 3) increased costs associated with rotating partners within a firm or among firms.
• Section 204. Auditor reports and audit committees. The company's auditor must prepare a report to the audit committee, noting: 1) all critical accounting policies and practices; 2) all alternative treatments of financial information; and 3) material written communications between the auditor and the company. Critical accounting policies (ie, inventory methods such as FIFO, LIFO, etc.), depreciation and amortization methods (straight line, accelerated, revenue recognition, etc.) and alternative accounting discussions of critical financial information (ie, revenues from long-term contracts, segment reporting, pro forma earnings issues, etc.), in most situations, will change infrequently and, therefore, discussions and understanding of these issues following the first auditor report should be straightforward. During the first audit report, and any subsequent reporting periods requiring discussion of such an issue, the audit committee should hire, considering the relative industry and accounting expertise of its board members, advisers as appropriate in order to assist in understanding the complexities of the issue and, if necessary, provide another independent analysis concerning the auditors' conclusions. Such a suitable adviser could be a university accounting professor, chief financial officer or other accounting officer from another company/competitor within the same industry sector, or a partner from another auditing firm. Most reputable auditing firms and financial consulting firms have resident experts designated by industry or accounting issue. Further, there are many competent forensic accounting consultants who provide consulting and expert witness testimony in matters involving disputes among multiple parties who could investigate and educate the audit committee on selected issues, as necessary.
• Section 207. Study of mandatory rotation of registered public accounting firms. Mandatory rotation of auditing firms would result in a similar set of positive and negative aspects, as discussed above. The company would lose the expertise and understanding gained by the audit partner and the auditors' staff, while gaining the insight and alternative thinking of a new firm. In any event, it appears that auditor rotation would result in increased costs, as a new firm would surely monitize the lost learning efficiency, relevant to the company's operations and industry.

Next month's conclusion to this article discusses Title III: Corporate Responsibility, and Title IV: Enhanced Financial Disclosures.

Part One of a Two-Part Article