Audit Committee Reporting Obligations

The increasingly responsible role of the independent audit committee of a board of directors has become, and will continue to become, more complex and more important. Various regulatory authorities continue to focus on and expand the role and responsibility of the independent audit committee, including not only its oversight role, but also its disclosure requirements. Among the regulatory authorities, the Public Company Accounting Oversight Board (PCAOB), the Securities and Exchange Commission (SEC) and stock exchange rules focus on the expanding role and responsibility of the independent audit committee.

Background

Since the enactment of the Sarbanes-Oxley Act of 2002 (SOX), regulatory focus has been directed toward improving auditor independence and the role of the audit committee as the gatekeeper and responsible entity for engaging, overseeing and monitoring the performance of independent auditors. In addition, since the creation of the PCAOB, literally hundreds of inspections of registered public accounting firms have occurred and continue to occur. Many of the inspections have resulted in finding significant deficiencies in audits examined, raising audit quality issues. Also, there is an increased focus on the part of investors and proxy advisers on the governance of audit firms, their independence, their objectivity, and thus the role of the audit committee in selecting the audit firm and overseeing these responsibilities.

As an integral part of the process, the PCAOB issued a concept release in August 2011, which, among other things, would have required mandatory auditor rotation. The focus of the proposed mandatory rotation was to enhance auditor independence and objectivity. While this concept has not and will not likely be implemented in the U.S., more emphasis is being given to the role and responsibility of the audit committee in overseeing the performance, the independence and the objectivity of the independent auditors.

As part of this continuing process, in July 2015, the SEC issued a Concept Release dealing with possible revisions and additions to required audit committee disclosures. It had been noted that many large issuers, a number of those among the S&P 500, were enhancing the disclosure of their respective audit committees. The Center for Audit Quality and Analytics disclosed in late 2015 a trend of companies voluntarily disclosing information in connection with external auditor oversight, the appointment of the external auditor, engagement partner selection, engagement partner rotation and other information regarding the role of the audit committee. The Concept Release's principal focus is on requirements for enhanced disclosure over the selection and oversight of independent auditors, and sets forth three principal areas for enhanced disclosure, requesting comments to a series of questions. In general, the three areas involve: 1) the oversight role of the audit committee over the independent auditor; 2) the process utilized by the audit committee in selecting or retaining the independent auditor; and, 3) the audit committee review and focus on the qualifications and related issues involving the independent auditor, including inspection reports.

In connection with the oversight role of the audit committee, the Concept Release notes the requirements of PCAOB Audit Standard No. 16 and required communications between the audit committee and the auditor, and seeks comments on potential additional disclosure areas related to these communications between the audit committee and the auditor, the nature of the communications, and matters involving discussions in private sessions with independent auditors. The oversight role as noted in the Concept Release also includes potential disclosure regarding PCAOB inspection reports, along with methods by which the audit committee examines and enforces objectivity and professional skepticism on the part of the auditor.

Regarding disclosures involving the process used by the audit committee in selecting or appointing the auditor, the Concept Release includes disclosures regarding the methods by which the committee assessed or evaluated the auditor, and the related rationale for the selection. If the audit committee solicited proposals, the Concept Release provides for disclosure of the process involved and factors considered in seeking proposals, and the policy or rationale adopted in connection with stockholder vote on approval of the selection of independent auditors.

As to assessment of the qualifications of the audit firm and the audit engagement team, the Concept Release is focused on disclosure of the engagement partner and related team members, together with their respective functions, the involvement of the audit committee in selection of the engagement partner and related audit team, and the tenure and related relationships with the audit firm, together with any required outsourcing of functions. Most of the comments provided on the Concept Release did not favor additional mandatory disclosure requirements, citing confidentiality, lack of demonstrated need for additional disclosure to investors, potential exposure on the part of the audit committee and lack of benefit to stockholders for the additional cost and burden placed on an audit committee.

One of the considerations in the Concept Release involved disclosure of the engagement partner on the audit, as well as additional members of the engagement team. In December 2015, the PCAOB adopted new rules that require auditors (not issuers) to disclose the name of the audit engagement partner, by filing with the PCAOB a new form AP for each audit of an issuer.

The rules also require disclosure of the names, location, and extent of participation of any other accounting firm that took part in the audit, to the extent that the involvement was more than 5% of the total audit hours expended, and the number and extent of participation of any other accounting firm that took part in the audit where participation was less than 5% of the total audit hours. The new rules differ from the initial PCAOB concept of requiring the engagement partner to sign the audit report, or to be named in the audit report. The current rule requires a separate filing. Although the rules are subject to approval by the SEC, the new rules are slated to become effective for audit reports issued on or after Jan. 31, 2017.

Currently, requirements involving audit committee disclosures are contained in Regulation S K, Item 407. As noted in the Concept Release, the requirements contained in Item 407 of Regulation S K involving audit committee disclosures were implemented in 1999. Although, the requirements of SOX, and the implementation of rules promulgated by the PCAOB, have made changes of significance in the role and responsibility of audit committees, no significant revisions have been made to the mandatory disclosure requirements of Item 407.

Following the July 2015 publication of the Concept Release, the SEC has received and published 102 comment letters and information regarding at least seven meetings and/or calls with representatives of the Office of Chief Accountant. Technically, the comment period for the Concept Release expired Sept. 8, 2015, but comments were received as late as February 2016. In general, most of the comments submitted were not favorable, focusing on the lack of demonstrated need for additional detailed disclosures, and concern regarding the additional burden required of audit committees. Concerns also were noted about the confidentiality of audit committee discussions with auditors and the potential chilling effect of disclosures.

There was some support from commenters regarding improvements and methods to improve current disclosures required of an audit committee. In general, additional information regarding activities of audit committees in connection with selection and appointment of the independent auditor, and the evaluation of the qualifications and performance of an audit team, together with related compensation arrangements, seem to be of interest to some of the commenters. Currently, it seems unlikely that proposed rulemaking will occur in the near future. However, the Office of the Chief Accountant has indicated that it is working closely with the Division of Corporation Finance and the PCAOB, and will continue to consider the comments and any potential recommendations that may be made to the Commission for additional disclosure. There has been encouragement provided for voluntary additional disclosures, tailored to the specific industry and issuer.

Next Steps

As shareholder activism continues to increase as well as activity of proxy advisers, demand for additional information and disclosures from audit committees likewise has increased. SEC Chief Accountant, James Schnurr, in an address to the AICPA National Conference, stated: “Audit committees play a critical role in providing oversight and serving as a check and balance on a company's financial reporting system ' . From my perspective, the increasing desire by investors to hear more from audit committees is understandable given the important role that audit committees play.” Given the increasing pressure for additional disclosure and the Concept Release issued by the SEC, an additional factor has developed.

The Enforcement Division of the SEC has indicated a renewed focus on oversight of financial reporting and requirements of SOX for internal control over financial reporting. It appears that the Enforcement Division continues to focus on matters involving internal controls, and whether an issuer has adequate internal controls to establish accurate financial reporting and prevent fraudulent activity. Based on these activities, over the last several years, the Center for Audit Quality has determined that a number of audit committees are focusing on expanded disclosure regarding duties and functions of the audit committee, particularly in the selection and oversight of external auditors. The more aggressive role of the SEC's Enforcement Division related to the audit and examination of internal controls, also has been a catalyst in expanding disclosures.

Given the current and likely expansion of the workload and commitment required of the audit committee, and the comments made in connection with the Concept Release by a number of commenters, it seems unlikely that the detailed requirements noted in the Concept Release will be implemented. However, given investor activism, SEC enforcement activity, and PCAOB inspections, it is suggested that audit committees should consider, voluntarily, enhancing certain aspects of disclosure in their respective audit committee report.

Actions to Consider

Going forward, it likely will be the case that a significant number of those entities making up the S&P 1500 will reflect enhanced audit committee disclosures. As a result, it is suggested that the following actions be considered for implementation by an audit committee prior to the 2017 proxy season.

1. Consider adding clarity and detail to the audit committee's policy on selection, retention and oversight of independent auditors;

2. Review each of the factors involved in connection with the committee's decision making regarding selection of independent auditors and document compliance with those factors;

3. Review similar peer group companies and their respective audit committee reports to develop a comparison to use as a benchmark;

4. Review all available PCAOB inspection reports on all audit firm candidates for selection as independent auditor and determine any weaknesses or criticisms and review in detail with the audit engagement team;

5. Develop a detailed policy for the committees' role and responsibility for overseeing or monitoring the audit process with the independent auditor;

6. Consider the factors to be addressed in determining compensation of the independent auditor for each specific role and any impact of non-audit service on independence;

7. Review and analyze key issues related to independence of the auditor, including relationships with management or board members, term of the current tenure, non-audit services performed and a general review of objectivity and professional skepticism of the lead participants of the independent auditor;

8. Consider, identify and select the lead audit engagement partner based upon analysis and qualifications and the identity of the engagement team, including any required outsourcing;

9. Consider any comments and observations from the internal audit function regarding the external auditor; and

10. Consider carefully the relevant topics to be addressed in connection with required communications between the audit committee and the auditor, being mindful of PCAOB Audit Standard No. 16.

Conclusion

Based on a number of indicators noted above, both the SEC and PCAOB, together with shareholder activism and various enforcement activities, indicate increased pressure on audit committees to consider providing additional disclosures in connection with activities involving selection and oversight of independent auditors. However, as evidenced by SEC chair Mary Jo White in an address to the 2015 AICPA National Conference on SEC and PCAOB Developments, “heavy demands” on audit committees could impair the ability of the committee to carry out its basic and core oversight functions. It was suggested that “the increasing workload may dilute an audit committee's ability to focus on its core responsibilities: selecting and overseeing the independent auditors; internal controls and auditing; setting up an appropriate system for receipt and treatment of complaints about auditing; and, reporting to shareholders.”

Given these comments and those from the Chief Accountant's Office, on current requirements and core responsibilities it also seems clear that both SEC and the PCAOB are focused on audit quality, internal controls over financial reporting and the base requirement that controls systems are adequate in order that financial statements are accurate, reliable and in compliance with GAAP requirements. As part of the functions of the audit committee and its core responsibilities, providing enhanced principle based disclosure to stockholders regarding audit committee functions and processes, should be considered.

William L. Floyd is senior counsel in the Atlanta office of Dentons US LLP. A member of this newsletter's Board of Editors, he may be reached at [email protected].