The Expanding Role of the Audit Committee

Since its creation, the PCAOB has conducted hundreds of inspections of registered public accounting firms, observing, in many instances, a lack of the independence, objectivity and professional scepticism required of an independent auditor. As a result of these findings, on Aug. 16, 2011, the PCAOB issued a “Concept Release” to solicit public comment on methods to: 1) enhance auditor independence; 2) increase objectivity and professional scepticism; and 3) generally increase or promote audit quality. One of the methods proposed in the Concept Release is mandatory auditor rotation.

To date, the Sarbanes-Oxley Act of 2002 has provided the bulk of the guidance of auditor independence. In drafting the Sarbanes-Oxley Act of 2002, Congress considered, but stopped short of implementing, mandatory auditor rotation. Most notably, Sarbanes-Oxley established the audit committee, rather than management, as the party responsible for hiring the independent auditor and overseeing the engagement. Sarbanes-Oxley also requires mandatory rotation of the lead audit partner by prohibiting the same partner from performing audit services for an issuer for more than five consecutive fiscal years. Based on the language in the Concept Release, it appears that the PCAOB believes Sarbanes-Oxley did not complete the task of assuring auditor independence and objectivity.

The PCAOB is not alone. Auditor independence has become an international concern. The European Commission has proposed legislation mandating audit firm rotation every six years. However, the European Parliament and EU member states reached a preliminary agreement on Dec. 17, 2013, which will require audit firms to rotate every 10 years, with extensions available under certain circumstance. The U.K. Competition Commission has issued draft guidance, to be codified, requiring all FTSE 350 firms to solicit or retender for engagement of an audit firm every five years. The Canadian Public Accountability Board is reviewing a requirement for a “mandatory comprehensive review” of independent auditors to be performed by independent audit committees.

Continuing Debate

Despite the proposals moving forward elsewhere, the PCAOB's proposals have been the focus of significant and continuing debate. In response to the Concept Release, the PCAOB received nearly 700 comment letters, and has conducted roundtable discussions in Washington, DC, San Francisco and Houston for the purpose of gaining additional insight from the public, panel members and participants. Opinions have spanned the spectrum.

Members of the five-member PCAOB board are divided in their support for the proposals. While Chairman Doty has expressed support for mandatory auditor rotation, other PCAOB board members have shared concerns. At the American Institute of Certified Public Accountants (AICPA) Regulatory Conference, PCAOB board member Jay Hanson indicated that he does not believe the board has sufficient evidence to support mandatory auditor rotation, noting that the JOBS Act of 2012 requires that any PCAOB standard must be implemented with evidence that reflects the benefits of the standard justify the cost of the new standard. The cost benefit analysis would require a study that analyzed the link between tenure and auditor independence, and audit failures and deficiencies, which, according to Hanson, has not been presented. Somewhat less specific, PCAOB board member Jeanette Franzel informed the AICPA that, in her view, the PCAOB is in the process of rethinking the Concept Release and will be seeking other methods to improve independence and the quality of audits.

The Audit Committee

Given the opposition to mandatory auditor rotation, based on comments from the public and PCAOB board members, it seems likely that the role and responsibility of the audit committee will increase. Potentially, to enhance auditor independence and objectivity, audit committees (fully independent of and operating without influence of management) may be required periodically, and perhaps annually, to prepare and furnish a formal evaluation of the functions of existing auditor, giving effect to the quality of their audit services, the degree of scepticism and objectivity shown by the auditor, the nature of the non-audit services they provide, the influence those services could have on independence, and in general, the relationship with and involvement of management in the audit process.

This evaluation will be used to justify retention or replacement of the auditor. As a start, in late October 2013, the PCAOB published Audit Alert No. 11, highlighting auditors' responsibility in risk assessment and the importance of controls used by a company to produce financial statements. The Alert admonishes audit committees to push auditors on audit plans to address internal controls and to provide detail to the committee on the audit firm's auditing deficiencies related to internal control identified in the firm's PCAOB inspection report.

Based on the amount of time and effort the PCAOB has exerted on the question of auditor independence and objectivity, and the PCAOB's comments and findings regarding its experience in connection with 10 years of inspections of registered public accounting firms, it appears likely that the PCAOB will propose new and additional requirements during 2014.

Continuing the focus on audit committee responsibility, several corporate governance organizations have recently issued a report, “Enhancing the Audit Committee Report: A Call to Action.” The National Association of Corporate Directors, the Association of Audit Committee Members, the Directors' Council, the Center for Audit Quality, and several others, issued the report that urges audit committees to reassess their reporting to company stockholders, detailing the role and enhanced responsibility of the audit committee. Among other items, the Call to Action suggests audit committees should provide more information to stockholders, and to the public, as to factors it considered in selection or reappointment of an audit firm, information about negotiation of fees and non-audit functions, and information about how the Committee oversees the audit and evaluates the quality of the audit.

What to Expect

Audit committees should expect additional burdens and responsibilities regarding auditor independence. Although it is possible that the PCAOB will impose mandatory auditor rotation for public issuers, it seems more likely the PCAOB will adopt the Canadian approach or portions of the UK approach (for FTSE 350 companies) and task the audit committee with detailed reporting obligations on, and formal evaluations of, the independent auditor. Such reports will likely be made part of a public company's periodic reporting requirements, and require the audit committee to provide the rationale and support for its decision either to retain or to replace the issuer's independent auditor.

Such a comprehensive review by the audit committee, coupled with preparing and publishing a formal evaluation, will, at a minimum, require the audit committee to probe the degree of scepticism and objectivity reflected by the auditor (independent from any management influence), the relationship between auditors or members of the audit firm and management (or board of directors), the nature of non-audit services provided by the audit firm, and the influence those services could have on auditor independence. Reviews also may be required to address any perceived issues.

For example, a significant complaint that has risen to the PCAOB level, and also is being addressed by the Financial Accounting Standards Board (FASB), relates to valuations and estimates of management used in connection with financial statement preparation, and the degree and nature of the auditor's independent examination and analysis of such vital audit functions. By installing a comprehensive review requirement, the audit committee would be tasked with ensuring that the auditor thoroughly examined the basis for such valuations and estimates.

It should be noted that the preliminary agreement between the European Parliament and EU member states, in addition to mandatory rotation of audit firms, also will limit or prohibit non-audit services. The proposed rules will limit tax advice and services related to financial and investment strategy. Overall, there will be a cap of 70% on fees generated for non-audit services (other than those services prohibited) based on a three year average. In order to promote greater competition among audit firms, the rules will prohibit “big four only” clauses from being imposed on companies. The new EU requirements are aimed at enhancing audit quality, reducing conflicts of interest and promoting investor confidence. The reforms are being finalized for approval.

While potential regulations may task the audit committee with reporting obligations, as the methods to ensure auditor independence continue to be debated, it is likely that the audit committee's responsibilities will be more comprehensive in the future. Some have suggested that audit committees will be tasked with ongoing responsibilities throughout the audit process, including the engagement of the independent audit firm, designing the scope of the audit, planning the audit process and periodically meeting with auditors and evaluating the audit, and quarterly reviews, on a continuing basis. The role of the audit committee to focus more specifically on audit quality also will be developing, which will require enhanced diligence. Independent counsel to the audit committee could serve to assist in the fulfilment of many of these obligations.

How to Prepare for Increased Responsibility

As the role of the audit committee evolves, audit committee members should consider engaging independent counsel to ensure the committee meets both existing and new requirements and that members meet their fiduciary obligations. The PCAOB inspection reports for 2013 reflect that the most significant audit deficiencies involve internal controls over financial reporting, and procedures to validate estimates and valuations. Audit committees should focus on these deficiencies in establishing and planning the audit process.

In preparing for additional duties and responsibilities and planning for the audit process, the role of independent counsel to the audit committee should be tailored to fit the individual company. For example, at a minimum, independent counsel can be engaged to periodically update the committee on new PCAOB and FASB standards and review of inspection reports from the PCAOB. Alternatively, independent counsel can serve as the audit committee's staff, not only educating the committee on the standards, but also ensuring compliance with those standards by outlining audit plans and procedures for approval, assisting with implementation of the plans and interfacing with the internal auditors.

There are many other options in between. While the scope of an engagement will vary to meet a committee's needs, as the responsibilities and thus exposure of the audit committee continues to grow, having independent counsel will become increasingly valuable and, in many instances, necessary.

William L. Floyd is Senior Counsel in the Atlanta office of McKenna Long & Aldridge LLP. His practice focuses on securities and corporate finance, mergers and acquisitions and corporate and regulatory matters, including corporate governance and responsibility. He can be reached at [email protected] or 404-527-4000.'

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The role the independent audit committee of a board of directors, not unlike the compensation committee, the nominating and governance committee, and perhaps a risk management committee, is becoming increasingly important as significant responsibilities shift to the board of directors. Regulatory authorities such as the Public Company Accounting Oversight Board (PCAOB) and the Securities and Exhange Commission (SEC) are focusing on and expanding the role and the responsibility of these committees. As part of this evolution, the audit committee, which was the first committee whose independence was mandated, continues to be the one whose role is evolving most rapidly and on which additional requirements are likely to be imposed.

In addition to regulation and oversight by the SEC, public company financial statements, and thus the audit committee, are affected by rulemaking of the PCAOB. The increased focus of investors on governance of audit firms, their independence and their objectivity, is likely to increase the role of the audit committee. In addition, the PCAOB's recent proposals and rulemaking with regard to auditor independence and objectivity suggest increasing responsibility for the audit committee. Along with this increasing responsibility, increasing exposure will result, and the need for independent counsel for the audit committee will intensify.

Background

Since its creation, the PCAOB has conducted hundreds of inspections of registered public accounting firms, observing, in many instances, a lack of the independence, objectivity and professional scepticism required of an independent auditor. As a result of these findings, on Aug. 16, 2011, the PCAOB issued a “Concept Release” to solicit public comment on methods to: 1) enhance auditor independence; 2) increase objectivity and professional scepticism; and 3) generally increase or promote audit quality. One of the methods proposed in the Concept Release is mandatory auditor rotation.

To date, the Sarbanes-Oxley Act of 2002 has provided the bulk of the guidance of auditor independence. In drafting the Sarbanes-Oxley Act of 2002, Congress considered, but stopped short of implementing, mandatory auditor rotation. Most notably, Sarbanes-Oxley established the audit committee, rather than management, as the party responsible for hiring the independent auditor and overseeing the engagement. Sarbanes-Oxley also requires mandatory rotation of the lead audit partner by prohibiting the same partner from performing audit services for an issuer for more than five consecutive fiscal years. Based on the language in the Concept Release, it appears that the PCAOB believes Sarbanes-Oxley did not complete the task of assuring auditor independence and objectivity.

The PCAOB is not alone. Auditor independence has become an international concern. The European Commission has proposed legislation mandating audit firm rotation every six years. However, the European Parliament and EU member states reached a preliminary agreement on Dec. 17, 2013, which will require audit firms to rotate every 10 years, with extensions available under certain circumstance. The U.K. Competition Commission has issued draft guidance, to be codified, requiring all FTSE 350 firms to solicit or retender for engagement of an audit firm every five years. The Canadian Public Accountability Board is reviewing a requirement for a “mandatory comprehensive review” of independent auditors to be performed by independent audit committees.

Continuing Debate

Despite the proposals moving forward elsewhere, the PCAOB's proposals have been the focus of significant and continuing debate. In response to the Concept Release, the PCAOB received nearly 700 comment letters, and has conducted roundtable discussions in Washington, DC, San Francisco and Houston for the purpose of gaining additional insight from the public, panel members and participants. Opinions have spanned the spectrum.

Members of the five-member PCAOB board are divided in their support for the proposals. While Chairman Doty has expressed support for mandatory auditor rotation, other PCAOB board members have shared concerns. At the American Institute of Certified Public Accountants (AICPA) Regulatory Conference, PCAOB board member Jay Hanson indicated that he does not believe the board has sufficient evidence to support mandatory auditor rotation, noting that the JOBS Act of 2012 requires that any PCAOB standard must be implemented with evidence that reflects the benefits of the standard justify the cost of the new standard. The cost benefit analysis would require a study that analyzed the link between tenure and auditor independence, and audit failures and deficiencies, which, according to Hanson, has not been presented. Somewhat less specific, PCAOB board member Jeanette Franzel informed the AICPA that, in her view, the PCAOB is in the process of rethinking the Concept Release and will be seeking other methods to improve independence and the quality of audits.

The Audit Committee

Given the opposition to mandatory auditor rotation, based on comments from the public and PCAOB board members, it seems likely that the role and responsibility of the audit committee will increase. Potentially, to enhance auditor independence and objectivity, audit committees (fully independent of and operating without influence of management) may be required periodically, and perhaps annually, to prepare and furnish a formal evaluation of the functions of existing auditor, giving effect to the quality of their audit services, the degree of scepticism and objectivity shown by the auditor, the nature of the non-audit services they provide, the influence those services could have on independence, and in general, the relationship with and involvement of management in the audit process.

This evaluation will be used to justify retention or replacement of the auditor. As a start, in late October 2013, the PCAOB published Audit Alert No. 11, highlighting auditors' responsibility in risk assessment and the importance of controls used by a company to produce financial statements. The Alert admonishes audit committees to push auditors on audit plans to address internal controls and to provide detail to the committee on the audit firm's auditing deficiencies related to internal control identified in the firm's PCAOB inspection report.

Based on the amount of time and effort the PCAOB has exerted on the question of auditor independence and objectivity, and the PCAOB's comments and findings regarding its experience in connection with 10 years of inspections of registered public accounting firms, it appears likely that the PCAOB will propose new and additional requirements during 2014.

Continuing the focus on audit committee responsibility, several corporate governance organizations have recently issued a report, “Enhancing the Audit Committee Report: A Call to Action.” The National Association of Corporate Directors, the Association of Audit Committee Members, the Directors' Council, the Center for Audit Quality, and several others, issued the report that urges audit committees to reassess their reporting to company stockholders, detailing the role and enhanced responsibility of the audit committee. Among other items, the Call to Action suggests audit committees should provide more information to stockholders, and to the public, as to factors it considered in selection or reappointment of an audit firm, information about negotiation of fees and non-audit functions, and information about how the Committee oversees the audit and evaluates the quality of the audit.

What to Expect

Audit committees should expect additional burdens and responsibilities regarding auditor independence. Although it is possible that the PCAOB will impose mandatory auditor rotation for public issuers, it seems more likely the PCAOB will adopt the Canadian approach or portions of the UK approach (for FTSE 350 companies) and task the audit committee with detailed reporting obligations on, and formal evaluations of, the independent auditor. Such reports will likely be made part of a public company's periodic reporting requirements, and require the audit committee to provide the rationale and support for its decision either to retain or to replace the issuer's independent auditor.

Such a comprehensive review by the audit committee, coupled with preparing and publishing a formal evaluation, will, at a minimum, require the audit committee to probe the degree of scepticism and objectivity reflected by the auditor (independent from any management influence), the relationship between auditors or members of the audit firm and management (or board of directors), the nature of non-audit services provided by the audit firm, and the influence those services could have on auditor independence. Reviews also may be required to address any perceived issues.

For example, a significant complaint that has risen to the PCAOB level, and also is being addressed by the Financial Accounting Standards Board (FASB), relates to valuations and estimates of management used in connection with financial statement preparation, and the degree and nature of the auditor's independent examination and analysis of such vital audit functions. By installing a comprehensive review requirement, the audit committee would be tasked with ensuring that the auditor thoroughly examined the basis for such valuations and estimates.

It should be noted that the preliminary agreement between the European Parliament and EU member states, in addition to mandatory rotation of audit firms, also will limit or prohibit non-audit services. The proposed rules will limit tax advice and services related to financial and investment strategy. Overall, there will be a cap of 70% on fees generated for non-audit services (other than those services prohibited) based on a three year average. In order to promote greater competition among audit firms, the rules will prohibit “big four only” clauses from being imposed on companies. The new EU requirements are aimed at enhancing audit quality, reducing conflicts of interest and promoting investor confidence. The reforms are being finalized for approval.

While potential regulations may task the audit committee with reporting obligations, as the methods to ensure auditor independence continue to be debated, it is likely that the audit committee's responsibilities will be more comprehensive in the future. Some have suggested that audit committees will be tasked with ongoing responsibilities throughout the audit process, including the engagement of the independent audit firm, designing the scope of the audit, planning the audit process and periodically meeting with auditors and evaluating the audit, and quarterly reviews, on a continuing basis. The role of the audit committee to focus more specifically on audit quality also will be developing, which will require enhanced diligence. Independent counsel to the audit committee could serve to assist in the fulfilment of many of these obligations.

How to Prepare for Increased Responsibility

As the role of the audit committee evolves, audit committee members should consider engaging independent counsel to ensure the committee meets both existing and new requirements and that members meet their fiduciary obligations. The PCAOB inspection reports for 2013 reflect that the most significant audit deficiencies involve internal controls over financial reporting, and procedures to validate estimates and valuations. Audit committees should focus on these deficiencies in establishing and planning the audit process.

In preparing for additional duties and responsibilities and planning for the audit process, the role of independent counsel to the audit committee should be tailored to fit the individual company. For example, at a minimum, independent counsel can be engaged to periodically update the committee on new PCAOB and FASB standards and review of inspection reports from the PCAOB. Alternatively, independent counsel can serve as the audit committee's staff, not only educating the committee on the standards, but also ensuring compliance with those standards by outlining audit plans and procedures for approval, assisting with implementation of the plans and interfacing with the internal auditors.

There are many other options in between. While the scope of an engagement will vary to meet a committee's needs, as the responsibilities and thus exposure of the audit committee continues to grow, having independent counsel will become increasingly valuable and, in many instances, necessary.

William L. Floyd is Senior Counsel in the Atlanta office of McKenna Long & Aldridge LLP. His practice focuses on securities and corporate finance, mergers and acquisitions and corporate and regulatory matters, including corporate governance and responsibility. He can be reached at [email protected] or 404-527-4000.'

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