Audit Committee Members: the Act Affects You!

Last month, we discussed the provisions of the Sarbanes-Oxley Act (the Act) that directly affect audit committees. These included Title II: auditor indpendence. This month, we discuss Title III: corporate resposibility, and Title IV: enhanced financial disclosures.

Title III: Corporate Responsibility

• Section 301. Public company audit committees. This section specifies that audit committees are directly responsible for appointment, compensation and oversight of the work of an auditor.

This section is clearly instrumental in advancing corporate governance, as it transfers the responsibility of engaging the auditor from management to the audit committee, and, thereby, aligning the scope of the auditor's objectives with those of the shareholders. There are several initial and ongoing issues for the audit committee to consider in this regard. First, the audit committee should consider if continuing engagement of the auditor is appropriate in light of the partner's and the firm's industry experience. This issue's relevance depends on the complexity, diversity and operations of the company.

Second, the audit committee must weigh the value of retaining versus changing the auditor solely based on economics. Audit committees should not be afraid to challenge the auditor's fees in fear that a change may send a negative message to a nervous marketplace. It has been recently reported that auditing fees have increased at an annual rate of as much as 30% depending on industry, location and perceived audit risk. This is a substantial increase that should not go unchallenged and needs, in certain circumstances, to be reasonably justified by the auditor.

Third, and likely most difficult, is oversight of the work of the auditor. Audit committees are required to be composed of at least two financially literate members and one financial expert. Depending on the complexity of the company in question, oversight may require: 1) a substantial amount of additional time by the committee members on an ongoing basis to review and analyze the company's operations (very important), financial results and unique accounting issues (ie, related party transactions, special purpose entities, off balance sheet issues, pro forma financial reconciliations, etc.); 2) more than the specified minimum number of three audit committee members; and 3) a significant amount of third-party expert legal, financial and accounting advisers.

It is important to note that because of this requirement, audit committee members require a significant amount of continuing education. The formulation of GAAP is fluid and complex, and is promulgated by a diverse group of professional organizations. Keeping on top of the latest issues requires a significant time commitment by any committee member.

Section 301 further indicates that in order to be considered independent, an audit committee member may not accept consulting, advisory or other compensatory fee (other than in their capacity as a board member) or be affiliated to the company. The SEC issued, as specified by the Act, specific rules that further refine compensation and affiliation matters. It should be noted that non-audit committee board members are not subject to these restrictions.

Under this section, audit committee members will be required to have more than a peripheral understanding of internal controls, as they relate to the operations of the company. Audit committee members should expect to spend a substantial amount of time reviewing and understanding the company's operations and internal controls on a business unit basis with management, auditor and outside advisors during the first year of the audit relationship, and certainly before any financial information is released to the investing public.

Section 301 also indicates that audit committees shall establish procedures for receiving, retaining and treating complaints regarding accounting, internal controls and auditing matters.

For large, complex and diverse companies, however, this could be a difficult provision with which to comply. The key is educating employees and establishing confidence that their reports will be confidential and remain anonymous. Systems could be paper, internet or phone-based (operated either internal or external through third-party vendors like Edcor or Report It) and should require that the tipster leave some basic information when calling in, such as: 1) the exact nature of the fraud; 2) how they came across the information; 3) whether the caller witnessed the fraud or key aspects of the fraud; and 4) whether the caller participated in any part of a fraud so that the alleged incident can be thoroughly investigated. A successful internal control system will most likely be designed, built and implemented thoroughly and efficiently. Failure to do such could result in excessive consumption of human resources, as they pursue insufficient reports and duplicate efforts among departments, while they chase frivolous tips.

Section 301 also indicates that audit committees shall have the authority and funding to engage independent counsel and other advisors.

Typically, audit committees should carefully consider the appropriateness of engaging the company's “day-to-day” outside counsel as its independent counsel. This could cause a conflict of interest, as counsel would be required to advocate both management and shareholders' interests. The audit committee's selection of independent counsel should be based on industry and relevant corporate governance experience. Industry, financial and accounting expertise, as indicated above, could come from several qualified sources.

Title IV: Enhanced Financial Disclosures

• Section 407. Disclosure of audit committee financial expert. This section requires that companies shall disclose whether or not (and if not, the reasons therefore) their audit committee contains at least one member who is a financial expert, based on specified criteria.

Because of the aforementioned educational requirement and the substantial time commitment, companies may find it difficult to identify and retain qualified board members. One expert has indicated that the field of potential audit committee board members has slimmed to active/retired accounting professors, audit partners and chief financial officers. This situation will make it difficult for companies to identify and hire qualified audit committee members within the time specified by the Act, and could also result in increased annual costs for such committee members. One study indicates that annual compensation for audit committee members has increased by 15% to 20% over last year.

Conclusion

The role of the audit committee has evolved at an increasing rate since 1940. The latest Act updates and revisions to audit committee roles have resulted in further enhanced accountability and authority of the corporate audit committee. These enhancements, however, will require a substantial increase in time, education, expertise and commitment for all audit committee members.

Readers, companies, audit committees and other affected interested parties should not rely solely on this discussion as a substitute for appropriate legal, financial and accounting advice as to applicable SEC rules, federal/state laws and local listing requirements.

Last month, we discussed the provisions of the Sarbanes-Oxley Act (the Act) that directly affect audit committees. These included Title II: auditor indpendence. This month, we discuss Title III: corporate resposibility, and Title IV: enhanced financial disclosures.

Title III: Corporate Responsibility

• Section 301. Public company audit committees. This section specifies that audit committees are directly responsible for appointment, compensation and oversight of the work of an auditor.

This section is clearly instrumental in advancing corporate governance, as it transfers the responsibility of engaging the auditor from management to the audit committee, and, thereby, aligning the scope of the auditor's objectives with those of the shareholders. There are several initial and ongoing issues for the audit committee to consider in this regard. First, the audit committee should consider if continuing engagement of the auditor is appropriate in light of the partner's and the firm's industry experience. This issue's relevance depends on the complexity, diversity and operations of the company.

Second, the audit committee must weigh the value of retaining versus changing the auditor solely based on economics. Audit committees should not be afraid to challenge the auditor's fees in fear that a change may send a negative message to a nervous marketplace. It has been recently reported that auditing fees have increased at an annual rate of as much as 30% depending on industry, location and perceived audit risk. This is a substantial increase that should not go unchallenged and needs, in certain circumstances, to be reasonably justified by the auditor.

Third, and likely most difficult, is oversight of the work of the auditor. Audit committees are required to be composed of at least two financially literate members and one financial expert. Depending on the complexity of the company in question, oversight may require: 1) a substantial amount of additional time by the committee members on an ongoing basis to review and analyze the company's operations (very important), financial results and unique accounting issues (ie, related party transactions, special purpose entities, off balance sheet issues, pro forma financial reconciliations, etc.); 2) more than the specified minimum number of three audit committee members; and 3) a significant amount of third-party expert legal, financial and accounting advisers.

It is important to note that because of this requirement, audit committee members require a significant amount of continuing education. The formulation of GAAP is fluid and complex, and is promulgated by a diverse group of professional organizations. Keeping on top of the latest issues requires a significant time commitment by any committee member.

Section 301 further indicates that in order to be considered independent, an audit committee member may not accept consulting, advisory or other compensatory fee (other than in their capacity as a board member) or be affiliated to the company. The SEC issued, as specified by the Act, specific rules that further refine compensation and affiliation matters. It should be noted that non-audit committee board members are not subject to these restrictions.

Under this section, audit committee members will be required to have more than a peripheral understanding of internal controls, as they relate to the operations of the company. Audit committee members should expect to spend a substantial amount of time reviewing and understanding the company's operations and internal controls on a business unit basis with management, auditor and outside advisors during the first year of the audit relationship, and certainly before any financial information is released to the investing public.

Section 301 also indicates that audit committees shall establish procedures for receiving, retaining and treating complaints regarding accounting, internal controls and auditing matters.

For large, complex and diverse companies, however, this could be a difficult provision with which to comply. The key is educating employees and establishing confidence that their reports will be confidential and remain anonymous. Systems could be paper, internet or phone-based (operated either internal or external through third-party vendors like Edcor or Report It) and should require that the tipster leave some basic information when calling in, such as: 1) the exact nature of the fraud; 2) how they came across the information; 3) whether the caller witnessed the fraud or key aspects of the fraud; and 4) whether the caller participated in any part of a fraud so that the alleged incident can be thoroughly investigated. A successful internal control system will most likely be designed, built and implemented thoroughly and efficiently. Failure to do such could result in excessive consumption of human resources, as they pursue insufficient reports and duplicate efforts among departments, while they chase frivolous tips.

Section 301 also indicates that audit committees shall have the authority and funding to engage independent counsel and other advisors.

Typically, audit committees should carefully consider the appropriateness of engaging the company's “day-to-day” outside counsel as its independent counsel. This could cause a conflict of interest, as counsel would be required to advocate both management and shareholders' interests. The audit committee's selection of independent counsel should be based on industry and relevant corporate governance experience. Industry, financial and accounting expertise, as indicated above, could come from several qualified sources.

Title IV: Enhanced Financial Disclosures

• Section 407. Disclosure of audit committee financial expert. This section requires that companies shall disclose whether or not (and if not, the reasons therefore) their audit committee contains at least one member who is a financial expert, based on specified criteria.

Because of the aforementioned educational requirement and the substantial time commitment, companies may find it difficult to identify and retain qualified board members. One expert has indicated that the field of potential audit committee board members has slimmed to active/retired accounting professors, audit partners and chief financial officers. This situation will make it difficult for companies to identify and hire qualified audit committee members within the time specified by the Act, and could also result in increased annual costs for such committee members. One study indicates that annual compensation for audit committee members has increased by 15% to 20% over last year.

Conclusion

The role of the audit committee has evolved at an increasing rate since 1940. The latest Act updates and revisions to audit committee roles have resulted in further enhanced accountability and authority of the corporate audit committee. These enhancements, however, will require a substantial increase in time, education, expertise and commitment for all audit committee members.

Readers, companies, audit committees and other affected interested parties should not rely solely on this discussion as a substitute for appropriate legal, financial and accounting advice as to applicable SEC rules, federal/state laws and local listing requirements.