Developing Role Of Audit Committees

Recent high-profile disclosures of alleged accounting irregularities have raised concerns about possible broader patterns of improper corporate accounting practices. Attention has focused on the fact that in 1998 it was reported that U.S. corporations announced charges totaling over $40 billion, including charges for restructuring, in-process research and development, merger related reserves and asset write-downs.¹ Concerns have also been raised with respect to practices involving revenue recognition and the deferral of expenses.

In an effort to find a solution to these perceived problems, commentators and regulators have identified the audit committee of the board of directors, as well as the accounting profession, as the institutional mechanisms bearing primary responsibility for ensuring the adequacy of internal financial controls and appropriate financial reporting.

Indeed, in a September 1998 speech, Arthur Levitt, Chairman of the Securities and Exchange Commission, stated that the "eroding quality" of earnings and financial reporting by public companies was a result of increasing pressure to meet or beat Wall Street earnings expectations, and that the corporate and financial communities should re-examine the role and function of the audit committee of the board of directors. Mr. Levitt noted that although a private sector response that empowers audit committees and obviates the need for public sector dictates was the wisest choice, the SEC stood ready to take appropriate action if investor interests were not protected.²

Over the years, the performance of audit committees has been studied and evaluated by academics, the accounting and legal professions and the SEC. Studies have recommended specific functions for the audit committee; the SEC, however, has only implemented very basic and limited mandates regarding audit committees. As illustrated by Mr. Levitt's remarks, however, renewed interest in audit committee initiatives is again a subject of debate.

Committee's Role

Under state corporate law, the management of the corporation is vested in the board of directors. Accordingly, directors are subject to fiduciary obligations to the corporation and its shareholders. While the board is not charged with the responsibility for the day-to-day operations of the corporation, the board's function is principally one of oversight of corporate management, policy and procedures. Directors are entitled under state law to reasonably rely on information provided by management and experts and may also delegate certain functions or responsibilities to a committee of the board. Such delegation, however, does not relieve the full board of its fiduciary obligations.³

In the modern corporation, the audit committee is typically delegated the responsibility of focusing on the corporation's financial reporting and internal financial controls. It has been observed that "[t]he primary functions of the audit committee are generally to recommend the appointment of the public accountants and review with them their report on the financial reports of the corporation; to review the adequacy of the system of internal controls and of compliance with material policies and laws, including the corporation's code of ethics and conduct; and to provide a direct channel of communication to the board for the public accountants and internal auditors and, when needed, finance officers, compliance officers, and general counsel."⁴

The American Institute of Certified Public Accountants has stated that an audit committee's main concerns include whether the corporation has controls to prevent and detect material fraud and errors and whether the audit process is adequate to provide reasonable assurance that the corporation's financial statements are fairly stated in accordance with generally accepted accounting principles.⁵

Audit committees interact with and rely upon management, and the internal and independent auditors. Indeed, generally accepted auditing standards require the independent auditor to assure itself that the audit committee is adequately informed on many subject matters, including illegal acts that come to the auditor's attention and significant deficiencies in the design or operation of the corporation's internal control structure which could adversely affect the corporation's financial reporting.

Auditing standards thus require the independent auditor to communicate matters to the audit committee that may assist the committee in performing its oversight responsibilities with respect to the corporation's financial reporting and disclosure, including (1) significant corporate accounting policies and the effect of such policies "in controversial or emerging areas for which there is a lack of authoritative guidance or consensus," (2) the accounting treatment utilized by management with respect to significant unusual transactions, (3) significant audit adjustments and (4) disagreements with management with respect to the application of accounting principles and the basis for management's judgment with respect to accounting estimates.⁶

In recent years, assessments have been made by the accounting and legal professions and corporate organizations leading to sophisticated recommendations of "best practices" for optimally functioning audit committees. Examples of best practices include the establishment of a written audit committee charter; careful selection of qualified committee members; the establishment of ongoing interaction with management, the internal audit function and independent auditors with the objective of influencing the corporation's financial reporting and regulatory compliance environment; the review and understanding of the corporation's business and financial risks and related controls with respect to risk management; coordination and monitoring of internal and external audit plans and their scopes; the review (with internal and external auditors and management) and understanding of the corporation's financial reports and disclosures; the monitoring of compliance with internal corporate policies and regulatory requirements; and the review by the audit committee of conflict of interest and related party transactions.⁷

Treadway Commission

One of the earliest comprehensive reports on the role of audit committees was issued by the National Commission on Fraudulent Financial Reporting, referred to as the Treadway Commission. The commission was a private sector initiative formed in 1985 and jointly sponsored by the American Institute of Certified Public Accountants, the American Accounting Association, the Financial Executives Institute, the Institute of Internal Auditors and the National Association of Accountants. Its 1987 report contained recommendations for detecting and preventing fraud in financial reporting, and it made specific recommendations with respect to the functions of an audit committee:

• Audit committees should be informed, vigilant and effective overseers of the financial reporting process and the company's internal controls.
• All public companies should develop a written charter setting forth the duties and responsibilities of the audit committee.
• Audit committees should have adequate resources and authority to discharge their responsibilities.
• An audit committee should review management's evaluation of factors related to the independence of the company's public accountant.
• Before the beginning of each year, an audit committee should review management's plans for engaging the company's independent public accountant to perform management advisory services during the coming year.
• Management and the audit committee should ensure that the internal auditors' involvement in the audit of the entire financial reporting process is appropriate and properly coordinated with the independent public accountant.
• Audit committees should oversee the quarterly reporting process.
• The SEC should require that the board of directors of all public companies establish audit committees composed solely of independent directors.
• All public companies should be required by SEC rule to include in their annual reports to stockholders management reports signed by management providing management's assessment of the effectiveness of the company's internal controls.
• All public companies should be required by SEC rule to include in their annual reports to stockholders a letter signed by the chairman of the audit committee describing the committee's responsibilities and activities during the year.⁸

Notwithstanding the Treadway Commission's recommendations for SEC mandates, the SEC has not adopted rules based on these specific recommendations. The New York Stock Exchange, however, requires all listed companies to have an audit committee consisting solely of independent directors, defined as directors who are free from any relationship that would interfere with the exercise of independent judgment; that is, directors who are affiliated with the company or an officer or employee of the company are not considered independent.⁹

The American Stock Exchange and the NASDAQ National Market System require audit committees consisting of a majority of independent directors.¹⁰ And corporations have voluntarily implemented many of the commission's recommendations.

Early SEC Actions

The SEC has not been silent on the issue of audit committees. It addressed the issue as early as 1940, when it issued a release endorsing the concept of non-officer audit committees having the responsibility of nominating an independent auditor and arranging some of the parameters of the independent auditor's engagement.¹¹

Since then, the SEC has issued releases concerning the existence, composition, duties and responsibilities of audit committees. In 1974, for example, it amended the proxy rules to require disclosure in proxy statements of the existence and composition of audit committees and the identity of audit committee members.¹²

In July 1978, the SEC issued a release proposing to amend the proxy rules to require a registrant to indicate whether each member of the audit committee was an independent director; a member of management or an individual who was not a member of management but affiliated with the company in another manner.

Disclosure of the number of meetings held by the audit committee also would have been required. The amendment also proposed seven "customary functions" of an audit committee which would be presumed to have been performed, and if not performed, the registrant would have been required to disclose. The functions included:

• engaging and discharging auditors;
• reviewing the engagement of the auditors, including the fee, scope and timing of the audit;
• reviewing with the auditors and management the company's policies and procedures with respect to internal auditing, accounting and financial controls;
• reviewing matters with the independent auditors upon completion of their audit, including their report or opinion; their perception of the company's financial and accounting personnel; the cooperation they received; the extent to which company resources were and should be used to minimize the time spent on the audit; significant transactions which are not a normal part of the company's business; changes in accounting principles and practices; all significant proposed adjustments and any recommendations they may have for improving internal accounting controls; and, choice of accounting principles or management systems;
• inquiring of the appropriate company personnel and the independent auditors as to deviations from established codes of conduct and periodically reviewing such policies;
• meeting with the company's financial staff at least twice a year to discuss internal accounting and auditing procedures and the extent to which recommendations made by the internal staff or by the independent auditors have been implemented; and
• reviewing significant press releases concerning financial matters.¹³

The proposed amendment evoked significant public reaction; almost 600 individuals and organizations submitted letters in response to the SEC's request for public comments. The most controversial proposal related to the effort to define "independent" and "management" directors. Commentators objected to the implicit premise that only persons meeting the definition of "independence" were capable of exercising disinterested and independent oversight and judgment.

Many were critical of the SEC's proposed "customary" functions of an audit committee. Respondents said that enumerating functions "customarily" performed by audit committees was necessarily prohibitive and would not address the needs of companies of varying sizes and concerns.

Respondents also were concerned that a "laundry list" approach would set a ceiling or lowest common denominator and discourage audit committees from performing different functions, thus deterring the evolution of audit committees. In December 1978, the SEC issued its final rules, requiring a registrant to provide in its proxy statement a brief description of significant economic and personal relationships between any director and the registrant as well as the functions actually performed by its audit committee and the number of meetings held; the SEC's proposed "customary" functions of an audit committee were not adopted.¹⁴

In 1988, the SEC proposed that public companies report on internal controls and financial reporting in annual reports to shareholders and annual reports on Form 10-K. Under the proposal, companies would have been required to report on: (1) management's responsibility for the preparation of financial statements, including estimates or judgments they might contain; (2) management's responsibility for establishing and maintaining a system of internal controls adequate to ensure the integrity and reliability of financial reporting; (3) management's assessment of the effectiveness of internal control systems as of the fiscal year end; and (4) management's responses to significant recommendations made during the year by both internal and external auditors concerning internal control systems.¹⁵

Public criticism cited cost considerations, lack of generally accepted criteria for assessing internal control adequacy and lack of safe harbor provisions for good faith efforts at compliance. This proposal was not adopted by the SEC.

Mr. Levitt's September 1998 speech included a proposal for a "blue ribbon" committee to make recommendations for improving audit committee performance; shortly thereafter, such a committee was formed by the New York Stock Exchange and the National Association of Securities Dealers. It recently issued its final report on improving the effectiveness of audit committees, which included recommendations with respect to the independence of directors, qualification requirements for directors, audit committee charters and disclosure of audit committee procedures in SEC filings. It also recommended that its proposed regulations be enforced through listing requirements imposed by the self-regulatory organizations (the SRO's).

Need for Caution

The consensus has been that an audit committee can serve an important and positive role in ensuring that a company's financial reporting system fairly represents its financial condition and that its internal controls system is functioning appropriately. Indeed, meaningful oversight by an audit committee can protect a company from not only potential litigation, but also criticism from the investment community. Nevertheless, the law of unintended consequences merits that any proposed solution be considered with caution.

First it is necessary to assess the scope and extent of the perceived problem. Certainly, high profile allegations of accounting irregularities give rise to legitimate questions as to the viability of the overall system; however, the observations on the state of financial reporting and disclosure appear to be grounded in anecdotal rather than empirical evidence.

Indeed, given the extensive disclosure requirements imposed by the SEC over the past 20 years, combined with efforts by the accounting profession with respect to evaluations and assessments of generally accepted accounting principles, as well as the heightened attention given both to financial reporting and corporate governance by the business, legal and accounting communities, one could plausibly argue that the quantity and quality of financial and corporate disclosure has dramatically improved.

Thus, before making significant changes to the current system, the case must be made that extensive reform is necessary and that solutions aimed at the conduct of audit committees are both viable and desirable. Consideration of reforms should apply some historical perspective which recognizes that proposals which have not been adopted previously may not have been adopted for sound reasons.

Further, solutions that are couched in terms of transparency and disclosure must be examined to determine whether their actual effect would be to either directly or indirectly influence the conduct of directors, particularly members of the audit committee, in the performance of their fiduciary and oversight responsibilities. Thus, efforts to impose federal requirements with respect to corporate governance matters could be viewed as an inappropriate intrusion into state law functions beyond the scope of the statutory authority of the SEC and the intended objectives of the SRO's.

The genius of state law governing fiduciary obligations of directors, particularly that of Delaware, is that it recognizes that courts and regulators are ill-equipped to assess business determinations and that corporate governance requires flexibility and dynamism, not bright-line rules. It will be important in the continuing debate, therefore, to distinguish between "best practices" and mandated conduct.

Imposing subject matter expertise qualification requirements for audit committee members may inappropriately infringe on the rights of shareholders to elect directors of their choosing. Qualification requirements may prevent a company from seeking attractive and qualified directors simply because they do not fit a mandated profile, and shareholders may have a more limited pool of director candidates from which to select.

The imposition of qualification requirements also fails to acknowledge that there is no single definitive set of requirements that adequately addresses the functions of all audit committees. While the ability to grasp financial or accounting concepts may be one important quality for at least some audit committee members, industry knowledge, business acumen and an understanding of the culture of the organization and the common sense ability and willingness to ask difficult questions, among other things, are also important.

The ABA, for example, noted that the most important qualifications of audit committee members are "common sense, general intelligence and an independent cast of mind."¹⁶ The imposition of qualification requirements for individual members of an audit committee also may not give enough weight to the fact that the resources and collective knowledge of a group are often far greater than the sum of the individual contributions.

In any event, to the extent expertise qualifications are imposed, one wonders how the SEC or SRO's would be in a position to monitor compliance and what sanctions would be imposed for violation - certainly delisting would be extreme.

Audit committee members, as members of the board of directors, should be subject to the same accountability standards to which all directors are held. Requiring audit committee members, in SEC filings, to certify financial statements or affirm their compliance with audit committee charters may subject these directors to liability exposure that other directors do not face, further discouraging qualified persons from serving.

Although the audit committees of many companies currently review financial statements together with management and external auditors, audit committee members have neither the expertise, time or resources to analyze company financial statements on their own. To impose certification obligations would suggest that audit committee members have much more of a hands-on financial role than is actually feasible for outside directors.

Further, it is unlikely that an independent director, who is not engaged in the day-to-day operations of a company, can periodically review a financial disclosure document and readily make an assessment as to its adequacy without reliance on representations of management and the report or observations of the company's independent auditors. Moreover, requiring certification of compliance with audit committee charters and other subjective concepts could likely result in the adoption of charters directed to the lowest common denominator to minimize hindsight criticism and not to the achievement of "best practices."

The board's oversight function applies not only to financial statements, but also to internal controls. A recent Delaware decision illustrates the effectiveness of state courts in addressing the fiduciary obligations of directors in this regard. In In re Caremark International Inc.,¹⁷ the Delaware Chancery Court considered whether a director's duty of care included a duty to monitor corporate law compliance.

The court found that the board of directors has a duty "to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists." To be adequate, the compliance system must be reasonably designed to provide management and the board with timely, accurate information such that management and the board may make informed judgments with respect to the company's compliance with law and business performance. Requiring audit committees to certify the adequacy of internal controls or the quality of accounting principles exceeds the standard set by the Delaware court.

Finally, any consideration to defining "independence" must be made with caution. Under current state corporate law, directors benefit from the business judgment rule, an evidentiary presumption that their business decisions are made by informed directors, in good faith, in the honest belief that they are acting in the best interests of the corporation and without a disabling conflict of interest. The burden is placed on the person challenging the decision to establish that the decision or the directors' approval of a transaction was made with "gross negligence" or that the decision or transaction was not approved by a majority of disinterested directors.

Care, therefore, must be made to avoid any definitions which could be used to disqualify directors, presently deemed to be disinterested under current state law, from being deemed "disinterested" in contexts outside that of the audit committee and, accordingly, being deprived of the protections of the business judgment rule. Moreover, in its release announcing that it would not adopt its 1978 proposal to impose specific criteria for determining "independence," the SEC noted the "[c]ommentators asserted that the term 'independent' conveyed a value judgment on the part of the Commission that persons meeting the Commission's definition of 'independent' not only are preferable to 'management' or 'affiliated nonmanagement' directors but are, in fact, the only persons who are capable of exercising disinterested oversight and independent judgment."¹⁸

The observations by those commentators critical of the 1978 proposal remain applicable with respect to any effort by regulators or SRO's to specifically apply bright line rules to the concept of "independence."

1. "Earnings Hocus Pocus: How Companies Come Up With the Numbers They Want," Business Week, Oct. 5, 1998.
2. "The 'Numbers Game' ", remarks of Chairman Arthur Levitt of the Securities and Exchange Commission, NYU Center for Law and Business, Sept. 28, 1998.
3. See generally Dennis J. Block, Nancy E. Barton & Stephen A. Radin, The Business Judgment Rule, 5th ed., 1998.
4. Statement On Corporate Governance, The Business Roundtable, September 1997.
5. Brochure of the AICPA, "Communication With Audit Committees."
6. See, e.g., AICPA Statement on Auditing Standards Nos. 54 (AU Section 317), 60 (AU Section 325) and 61 (AU Section 380).
7. See. e.g., Section of Business Law, American Bar Association, Corporate Directors Guidebook (1994 edition); "Global Best Practices for Audit Committees," Arthur Andersen (1998).
8. James C. Treadway Jr., Chairman, Report of the National Commission on Fraudulent Financial Reporting (Treadway Report), Washington D.C., National Commission on Fraudulent Financial Reporting, 1987.
9. NYSE Listed Company Manual at Section 303.00.
10. See ASE Company Guide at Section 121; NASD Marketplace Rules at 4460.
11. SEC Accounting Series Release No. 19 (1940).
12. SEC Accounting Series Release No. 165 (1974).
13. SEC Securities Exchange Act of 1934 Release No. 14970 (1978).
14. SEC Securities Exchange Act of 1934 Release No. 15384 (1978).
15. SEC Securities Exchange Act of 1934 Release No. 25925 (1998).
16. Section of Business Law, American Bar Association, Corporate Director's Guidebook (1994 edition). See also, Improving Audit Committee Performance: What Works Best, a Research Report Prepared by Price Waterhouse (1993).
17. In re Caremark International Inc., 698 A2d 959, 970.
18. SEC Securities Exchange Act of 1934 Release No. 15384 (1978).

Dennis J. Block and Jonathan M. Hoff are members of Cadwalader, Wickersham & Taft. Associate Jacqueline Lee Kadin, assisted in the preparation of this article.

This article is reprinted with permission from the February 25th issue of the New York Law Journal © 1999 NLP LP Company.