The SEC recently adopted final rules regarding corporate audit committees and financial statement reliability, effective January 31, 2000. The SEC also approved rule changes proposed by NYSE, NASD, and AMEX, effective December 14, 1999. The new rules are designed to improve disclosure related to the functioning of audit committees and to enhance the reliability and credibility of financial statements of public companies. Not surprisingly, the SEC rules focus largely on disclosure of audit committee activities, while the Exchange rules relate more to committee composition and role. The SEC, NYSE, and NASD rules allow for a transitional period for compliance. Most notably, the NYSE and NASD rules each require the adoption of a formal written audit committee charter by June 14, 2000. Compliance dates for the other rules are listed below.
Following is a brief summary of the new requirements.
SEC Rules
- Quarterly Financial Statement Review; Supplemental Information
For quarters ended after March 15, 2000, a company.s interim financial statements must be reviewed by an independent public accountant prior to the company.s filing its Form 10-Q or 10-QSB with the Commission. In addition, all companies are now required to supplement Item 302(a) of Regulation S-K which requires reconciliations and descriptions of adjustments to the quarterly information previously reported in a prior Form10-Q. Companies not previously subject to Item 302(a) must now comply with its requirements after December 15, 2000.
- Disclosure in Proxy Statement of Audit Committee Communications with Management and Independent Auditors
The audit committee must provide a report in the company.s proxy statement disclosing whether the audit committee has: (1) reviewed and discussed the audited financial statements with management; (2) discussed the matters required to be discussed with the independent auditors by Statement on Auditing Standards No. 61 (requiring an independent auditor to communicate to the audit committee information regarding the significant accounting policies used, accounting estimates, unusual transactions, controversial or emerging areas, adjustments arising from the audit, and disagreements with management related to accounting principles); (3) received written disclosures from the independent auditors, and discussed with the auditors the auditors. independence; and (4) recommended to the Board of Directors that the financial statements be included in the Annual Report on Form 10-K or 10-KSB.
The Company must also disclose in its proxy statement whether the audit committee is governed by a charter, and if so, the Company must include a copy of the charter in the proxy statement at least once every three years.
The SEC has provided a transition period for compliance with the new requirements. Companies must comply the requirements for all proxy statements relating to votes of shareholders occurring after December 15, 2000.
- Proxy Statement Disclosure of Audit Committee Members. "Independence"
Companies whose securities are listed on the NYSE or AMEX or quoted on Nasdaq that have a non-independent audit committee member (pursuant to NYSE, AMEX, or NASD provisions) must disclose in their proxy statements the nature of the relationship that makes that individual not independent and the reasons for the Board.s determination to appoint the director to the committee. Companies whose securities are so listed or quoted must also disclose whether the audit committee members are independent as defined in the applicable listing standards. Companies whose securities are not so listed or quoted must disclose whether, if they have an audit committee, the members are independent as defined in the NYSE.s, AMEX.s or NASD.s listing standards, and which definition is used. Companies must comply with these proxy and information disclosure requirements for all proxy and information statements relating to votes of shareholders occurring after December 15, 2000.
- Safe Harbor
The rules include a limited "safe harbor" for the audit committee report to protect the company and the directors from certain liabilities under the safe harbor law. However, the safe harbor does not extend protection to private securities litigation. It is unclear what additional exposure may be created by the audit committee report disclosure requirements.
Nasdaq Audit Committee Rules
- Audit Committee Charter
Nasdaq requires that issuers listed as of December 14, 1999, the effective date of the rule change, adopt a formal written audit committee charter by June 14, 2000. The charter must specify the scope of the audit committee.s responsibilities and how they will be carried out, including the committee.s responsibility for overseeing the independence of the outside auditor and the outside auditor.s ultimate accountability to the board of directors and the audit committee.
- Membership
The audit committee must have at least three members, and must be comprised solely of independent members, with the exception that one non-independent director may serve on the audit committee if the board of directors determines that it is in the best interests of the corporation and its shareholders, and discloses its reasons for such determination in the next annual proxy statement. However, no current employees or officers, or their immediate family members may serve on the audit committee under this exception. Companies listed as of December 14, 1999, must meet these structure and membership requirements by June 14, 2001.
Each member of the audit committee must be able to read and understand fundamental financial statements, or become able to do so within a reasonable period of time after appointment to the committee, and at least one member of the committee must have past employment experience in finance or accounting, requisite certification in accounting, or any other comparable experience or background, including having been a CEO, CFO or other senior officer with financial oversight responsibilities.
Nasdaq narrowed its former definition of "independent director" by specifying five new relationships that could impair a director.s independent judgment. This definition applies to all directors, not just audit committee members. The following directors will not be considered independent:
- those employed by the company or any of its affiliates for the current year or any of the past three years;
- those accepting any compensation from the corporation or any of its affiliates in excess of $60,000 during the previous fiscal year (with certain exceptions);
- those having a member of his or her immediate family who is, or has been in any of the past three years, employed by the company or its affiliates as an executive officer;
- a partner, controlling shareholder, or executive officer of any for-profit business organization to which the company made or received payments exceeding five percent of the company.s consolidated gross revenues for that year, or $200,000, whichever is greater, in any of the past three years (with certain exceptions);
- those employed as an executive of another entity where any of the company.s executives serve on that company.s compensation committee.
Small Business Filers are exempt from the composition requirements and will be held to Nasdaq.s existing requirements for audit committee membership (at least two members, a majority of whom are independent).
NYSE Audit Committee Rules
The NYSE rules mirror those of Nasdaq to a great extent, but there are a few differences. For example, the NYSE and Nasdaq rules do not use the same definitions of financial literacy and expertise or the test for determining when a potential director has a significant business relationship with the company. All of the NYSE rules are summarized below.
- Audit Committee Charter
The NYSE requires that the Board of Directors adopt and approve a formal written charter for the audit committee by June 14, 2000. The charter must specify the following: (1) the scope of the audit committee.s responsibilities and how they are carried out; (2) the ultimate accountability of the outside auditor to the board and audit committee; (3) the audit committee.s and board.s responsibility for selecting, evaluating and replacing the outside auditor; (4) and the audit committee.s responsibility for ensuring the independence of the outside auditor by reviewing, and discussing with the board if necessary, any relationships between the auditor and the company or any other relationships that may adversely affect the auditor.s independence.
- Membership
Companies must meet the following audit committee structure and membership requirements by June 14, 2001, except that all public company audit committee members qualified under current NYSE rules will be "grandfathered" by the Exchange until they are reelected or replaced. The audit committee must consist of at least three directors, each having no relationship to the company that may interfere with the exercise of their independence from management and the company. Each member of the audit committee must be "financially literate," as interpreted by the Board of Directors in its business judgment, or must become "financially literate" within a reasonable period of time after appointment to the committee. At least one member of the audit committee must have accounting or related financial management expertise, as interpreted by the Board.
Audit committee members must be independent, as defined, in part, by the following four restrictions:
- A director who is an employee or executive officer of the company or any of its affiliates may not serve on the audit committee until three years following the termination of the employment;
- A director who (1) is a partner, controlling shareholder, or executive officer of an organization having a business relationship with the company, or (2) has a direct business relationship with the company, may not serve on the audit committee until three years following the termination of the relationship, unless the company.s Board of Directors determines in its business judgment that the relationship does not interfere with the director.s exercise of independent judgment. In making this determination, the Board should consider, among other things, the materiality of the relationship to the company, to the director, and to the organization with which the director is affiliated, if applicable;
- A director who is employed as an executive of another corporation where any of the company.s executives serves on that corporation.s compensation committee may not serve on the audit committee;
- A director who is an immediate family member of an individual who is an executive officer of the company or any of its affiliates cannot serve on the audit committee until three years following the termination of such employment.
AMEX Audit Committee Rules
- Audit Committee Charter
AMEX requires those companies listed as of December 14, 1999, to adopt a formal written audit committee charter by June 14, 2000. The charter must specify the scope of the audit committee.s responsibilities and how they will be carried out, including the committee.s responsibility for overseeing the independence of the outside auditor and the outside auditor.s ultimate accountability to the board of directors and the audit committee.
- Membership
The audit committee must have at least three members, and must be comprised solely of independent members, with the exception that one non-independent director may serve on the audit committee if the board of directors determines that it is in the best interests of the corporation and its shareholders, and discloses its reasons for such determination in the next annual proxy statement. However, no current employees or officers, or their immediate family members may serve on the audit committee under this exception. Companies listed as of December 14, 1999, must meet these structure and membership requirements by June 14, 2001.
Each member of the audit committee must be able to read and understand fundamental financial statements, or become able to do so within a reasonable period of time after appointment to the committee, and at least one member of the committee must have past employment experience in finance or accounting, requisite certification in accounting, or any other comparable experience or background, including having been a CEO, CFO or other senior officer with financial oversight responsibilities.
AMEX narrowed its former definition of "independent director" by specifying five new relationships that could impair a director.s independent judgment. This definition applies to all directors, not just audit committee members. The following directors will not be considered independent:
- those employed by the company or any of its affiliates for the current year or any of the past three years;
- those accepting any compensation from the corporation or any of its affiliates in excess of $60,000 during the previous fiscal year (with certain exceptions);
- those having a member of his or her immediate family who is, or has been in any of the past three years, employed by the company or its affiliates as an executive officer;
- a partner, controlling shareholder, or executive officer of any for-profit business organization to which the company made or received payments exceeding five percent of the company.s consolidated gross revenues for that year, or $200,000, whichever is greater, in any of the past three years (with certain exceptions);
- those employed as an executive of another entity where any of the company.s executives serve on that company.s compensation committee.
Small Business Filers are exempt from the composition requirements and will be held to AMEX.s existing requirements for audit committee membership (at least two members, a majority of whom must be independent).