Improving the Effectiveness of Audit Committees

Journal Issue

May 1999

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It seems that each week The Wall Street Journal reports a major corporation replacing its chief

executive officer and/or restating its reported earnings due to prior aggressive accounting or

misstatements. Board of Directors Audit Committees are to monitor these issues, and serve an

extremely important function. They are designed to monitor the conditions and cultures of

corporate environments to ensure the quality and integrity of all financial statements. In other

words, they are the corporate watchdogs.

The audit committee is a key ingredient to ensure the reliability and integrity of the

company's financial statements and the process. However, the committee's broader role is to

help identify and protect the company from risks that can harm its financial condition, and

hence its shareholder value. Unfortunately, audit committees do not always have the proper

tools and power to fulfill their role effectively. It is one of the most challenging board

assignments, one with the responsibility of constantly monitoring management.

Director's Alert, a newsletter for Fortune 1,000 CEOs and directors, recently formed a

special panel to discuss how to improve the effectiveness of audit committees. The panel

concentrated on determining what audit committees can do to obtain the power and tools needed to

fulfill their role as corporate watchdogs.

The panel was comprised of seasoned corporate directors and industry experts that are

intimately familiar with the politics of the boardroom.<a href="#2" name="2a">2</a> Collectively, the panel identified the

following key challenges facing audit committees and offered practical strategies to meet those

challenges. The key challenges are as follows.

<h3>Stake Out the Audit Committee's Authority</h3>

Over the years, experts have agreed that the external auditor should regard the audit

committee, not management, as its client. This is easier said than done. The audit committee may

have hiring authority, but in reality, the external auditor will consider management, not the

board, as its client.

Action: It is crucial that the audit committee establish definite policies and procedures for

the flow of information. Frequent meetings should be conducted with all the key players to

maintain open lines of communication and determine, in advance, when and how information is

passed on to the audit committee.

At a minimum, the board should require prior notification to the audit committee regarding

proposed changes in accounting principles, disputed items between management and the external

auditors, significant changes by management in its estimates and any decision management to use

a non-GAAP application, even if such application is not then considered material.

In addition, the committee should require that management notify them in advance of any

intentions to replace or demote either the CFO or the internal auditor. Also, the committee

should annually review the budget and staffing for the internal audit function.

<h3>Know the Dynamics of the Company's Business</h3>

Different industries and businesses face different challenges and risks. It takes time and effort

to get up to speed on what issues are key in a particular company's marketplace, and where the

pitfalls lie.

Action: The committee should develop an action plan in conjunction with the internal auditor,

external auditor, the financial management team, general counsel and the CEO. The focus of the

plan should be to identify the immediate and long-term risks and exposures the company faces.

The audit committee also needs to be aware of areas where financial reporting is most likely to

be manipulated.

It would be beneficial to invite the individual department or division operating chiefs to attend

audit committee meetings. The staff can brief the committee on its business, providing a more

in-depth company profile, as well as insight into the strengths and weaknesses of the personnel.

<h3>Understand the Tone and Quality of the Company's Financial Policies</h3>

The audit committee should take the time needed to understand the subjective areas in the

company's financial statements.

Action: The audit committee should request a qualitative assessment of the company's financial statements from the external auditors. Directors must require that the external auditor:

<ul>

<li>describe whether management's approach to accounting is conservative, moderate or

aggressive from the perspective of income and asset and liability recognition;

</li><li>describe whether its methods are common practices in that industry or in the minority;

</li><li>describe the reasoning behind the auditor's determinations; and

</li><li>describe the completeness and clarity of the financial disclosure accompanying the report.

</li></ul>

<h3>Judge the Independence of the External Auditor</h3>

Technical guidelines make clear the types of relationships that impair the independence of an

auditor and the objectivity of the audit. Both may be compromised if the auditing firm has

substantial consulting contracts with the client. A similar problem surfaces when the audit fees

that a company pays represent a major portion of the particular audit firm's overall office

revenue.

Action: The audit committee should monitor the amount of consulting business the audit firm gets

from the company. The committee should also require that management inform them of any new

consulting contracts that are being negotiated with the company's auditors.

The committee should also carefully review any proposals to outsource either the internal audit

function, management information systems or information technology to the company's audit

firm. If not properly controlled, the auditors could end up auditing their own work. Any plans

along these lines should be carefully scrutinized to make sure they do not create conflicts of

interest.

<h3>Recognize Pressure from Wall Street for Short-term Results</h3>

Catering to Wall Street's demand for short-term results often puts pressure on management to

"manage to meet expectations."

Action: Inquire as to the long-term effects of new accounting principles or methods. Know key signs of financial manipulation and fraud, such as:

<ul>

<li>cash flow problems;

</li><li>requests to change outside auditors;

</li><li>large unusual transactions;

</li><li>material transactions with affiliated companies;

</li><li>overly complex transactions that suggest form over substance;

</li><li>missing records;

</li><li>unusual variances in financial results;

</li><li>significant changes in income tax rates;

</li><li>tips or complaints from employees, customers or others; and

</li><li>sudden turnover in key management positions or positions left unfilled for extended periods.

</li></ul>

<h3>Match Internal Controls to Today's Rapidly Changing Corporate Landscape</h3>

The rapid pace of new developments and breakthroughs in information technology and systems

further complicates the audit committee's job. Create processes and internal control systems

that work. The systems must be monitored for compliance and fine-tuned on an ongoing basis.

Action: Basic internal controls should include the segregation of duties, control over blank

checks, facsimile signatures and check sequence, timely reconciliation of general ledger

accounts with review by appropriate levels of management, periodic physical inventory counts,

reconciled to the general ledger with discrepancies investigated, proper authorization, support

and documentation for all transactions and journal entries, formal internal audit function

within the company that reports to outside directors, use of budgets, comparisons to actual

results and proper investigation of variances and unexpected results.

There is a misconception that most major frauds are complex financial transactions planned and

perpetrated by criminal masterminds. At its core, fraud is simple—the same basic methods or

techniques are seen over and over again, and they appear in companies of all sizes. The

magnitude of fraud is propelled much more by the environment in which it occurs than by the

novelty or sophistication of the fraud technique.

<h3>Encourage an Atmosphere of Constructive Tension with Management</h3>

The audit committee should be comprised of individuals with inquisitive minds and a variety of

skill sets and experience.

Action: The nominating committee, not the CEO, should decide who is on the audit committee. It

should be a diversified group, made up of seasoned professionals with a variety of skill sets and

experience.

This is not a training ground for new or inexperienced directors. The audit committee, and

especially the audit committee chairman, should be compensated fairly. Demands on audit

committees are great and compensation should not be a disincentive.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> For a detailed explanation of the action plans for these challenges, contact Rob Rock at (248) 358-4420. <a href="#1a">Return to article</a>

<a name="2">2</a> The panel experts were: Barbara H. Franklin, president and CEO of Barbara Franklin Enterprises; Roderick M. Hills, an attorney and former chairman of the

Securities and Exchange Commission; Karen N. Horn, managing director at Bankers Trust; Donald J. Kirk, former partner with Price Waterhouse and chairman of

the Financial Accounting Standards Board; Thomas J. Neff, chairman of SpencerStuart, U.S.; Rob Rock, principal with Jay Alix & Associates; Mary Schapiro, a

member of the board of the National Association of Securities Dealers Inc. and president of NASD Regulation Inc.; Lou Simpson, president and CEO, Capital

Operations of Geico Corp. <a href="#2a">Return to article</a>

Journal Authors

Molly Butler Hart

Robert J. Rock

Journal Date

Saturday, May 1, 1999 - 12:00