To Our Public Company Clients:
As most of you probably are already aware, the SEC as well as the NYSE, AMEX and NASDAQ have recently adopted new rules governing Audit Committees of the Boards of Directors of publicly traded companies, effective January 31, 2000. We know that the auditors for most of our public company clients have brought the new rules to the attention of their clients’ CFOs and/or Audit Committees. However, we believe some officers and directors do not fully understand what is required and when it will be required. In an effort to clarify the situation, we describe the new rules below.
Executive Summary
The following are the key requirements of the new rules and their respective effective dates:
Review of New Rules
Reasons for the New Rules
The SEC and the exchanges believe new rules will improve disclosure about the functioning of Audit Committees and enhance the reliability and credibility of the financial statements of public companies. The new rules were adopted in response to continuing concerns about inappropriate "earnings management," where companies distort their financial performance in order to maintain positive earnings trends or meet financial analysts’ expectations. According to the SEC, additional disclosures about a company’s Audit Committee and its interaction with the company’s auditors and management will promote investor confidence in the integrity of the financial reporting process. The SEC also believes that a higher level of scrutiny by independent auditors of companies’ quarterly financial statements should lead to more reliable financial information about companies throughout the reporting year and, therefore, fewer year-end audit adjustments.
Quarterly Review by Auditors
Beginning with the first fiscal quarter ending on or after March 15, 2000, all public companies are required to have their independent auditors review each of the three quarterly interim financial statements to be filed on Form 10-Q (or Form 10-QSB) with the SEC. In their review, the independent auditors must use professional standards and procedures for conducting reviews, as established by generally accepted auditing standards. This means that the auditors must follow the procedures set forth in SAS 71, which is substantially less in scope than an audit and does not result in an auditor’s opinion regarding the financial statements taken as a whole. In connection with their quarterly review, the auditors must apply a series of analytical procedures to the financial data and must discuss matters such as any significant adjustments, management judgments and accounting estimates, significant new accounting policies and disagreements with management. If a company states in its Form 10-Q filing that the interim financial statements have been reviewed by its auditors, a report of the auditors on the review must be filed with the Form 10-Q.
The SEC has also expanded the scope of companies required to provide selected quarterly financial data in their Annual Reports. Previously, SEC rules required only large, widely held companies to include summary quarterly financial data. Under the new rule, all public companies with securities registered on a national securities exchange, with a few limited exceptions, must include these quarterly data. This requirement applies to all Annual Reports to Shareholders dated after December 15, 2000.
Audit Committee Charter
For each Proxy Statement for a shareholder meeting scheduled after December 15, 2000, all public companies must also disclose in its Proxy Statement whether its Audit Committee is governed by a charter, and, if so, include a copy of this charter as an appendix to the Proxy Statement at least once every three years. The Audit Committee is required to review and reassess the adequacy of the charter on an annual basis. During the review process, the Audit Committee should consider the detail included in the charter to avoid unnecessary disclosure and related legal exposure.
The SEC’s new rules do not require a company to adopt an Audit Committee charter or dictate the content of a charter if one is adopted. However, each of the NYSE, AMEX and NASDAQ has implemented revised listing standards that require an Audit Committee charter and dictate its content. By June 14, 2000, all companies listed on the NYSE, AMEX or NASDAQ must adopt a formal written Audit Committee charter and have it approved by the Board of Directors.
The Audit Committee charter must specify:
All three exchanges’ new listing standards require that each Audit Committee must consist of at least three directors, comprised solely of independent directors as defined above.
Independence of Audit Committee Members
Proxy Statement Disclosure
Beginning with Proxy Statements for shareholder meetings scheduled after December 15, 2000, the SEC requires each company with listed or quoted securities to disclose whether each of the Audit Committee members is independent.
In only exceptional and limited circumstances, a company may appoint to its Audit Committee one director who is not independent. If a company chooses to make such an appointment, the Board of Directors must conclude that the membership of the individual on the Audit Committee is in the best interests of the company and its shareholders, and the company must disclose in its next Proxy Statement the reason the individual is not independent and the reasons for its determination to appoint the director to the Audit Committee.
The SEC also requires companies whose securities are not listed on the NYSE or AMEX or quoted on NASDAQ to disclose in their Proxy Statements whether, if they have an Audit Committee, the members are independent as defined in listing standards of the NYSE, AMEX or NASDAQ. While these companies are free to apply any of the three definitions of independence, they may adopt only one and must use it consistently to qualify all members of the Audit Committee.
Requirements for Independence of Members
Effective June 14, 2001, companies with securities listed on the NYSE or AMEX or quoted on NASDAQ must comply with the Audit Committee structure and membership requirements established by the applicable exchange. While these new listing standards are substantially similar to each other, the NYSE standards differ from those of the AMEX and NASDAQ in some respects. The NYSE adopted rules defining the independence of Audit Committee members, while the AMEX and NASDAQ adopted a new definition of "independent director" that applies to all directors, not just those serving on the Audit Committee.
Under the new listing standards, a director having any of the following relationships with the company will not be deemed to be independent.
Standards for Audit Committee Members
Under all three exchanges’ new listing standards, each member of the Audit Committee must be "financially literate;" that is, able to read and understand fundamental financial statements or must become financially literate within a reasonable period of time after his or her appointment to the Audit Committee.
Report of Audit Committee
The Audit Committee’s report must state whether the Audit Committee has:
The names of the company’s Audit Committee members must appear at the end of the Audit Committee report. The SEC believes that disclosure of the report will inform shareholders of the Audit Committee’s level of oversight over the company’s financial reporting and underscore the importance of that oversight.
We would be pleased to provide you with further information about these new rules and answer your questions about them. Also, we would be glad to assist you in drafting your Audit Committee charter and in determining the "independence" of the company’s current directors and the financial literacy of the members of the Audit Committee.
As most of you probably are already aware, the SEC as well as the NYSE, AMEX and NASDAQ have recently adopted new rules governing Audit Committees of the Boards of Directors of publicly traded companies, effective January 31, 2000. We know that the auditors for most of our public company clients have brought the new rules to the attention of their clients’ CFOs and/or Audit Committees. However, we believe some officers and directors do not fully understand what is required and when it will be required. In an effort to clarify the situation, we describe the new rules below.
Executive Summary
The following are the key requirements of the new rules and their respective effective dates:
- SAS 71 Review of Quarterly Financial Statements. Beginning with the first quarter of 2000, all public companies are required to have their independent auditors review each of the three quarterly financial statements to be filed on Form 10-Q. This review must be conducted in accordance with the requirements of SAS 71, which consists principally of applying analytical procedures to the financial data and making inquiries of the company’s officers responsible for financial and accounting matters.
- Audit Committee Charter. The new rules of the NYSE, AMEX and NASDAQ require each listed company to adopt a written charter by June 14, 2000. Beginning with each Proxy Statement for a shareholder meeting scheduled after December 15, 2000, the Proxy Statement must disclose whether the Audit Committee has adopted a written charter governing the committee’s responsibilities and functions. Under the new SEC rules, the charter must be included as an appendix to the Proxy Statement at least once every three years.
- Composition of Audit Committee. The listing standards of each of the exchanges now require that there be at least three independent directors on the Audit Committee.
- New Definitions of "Independence" for Members of the Audit Committee. Effective June 14, 2001, the exchanges’ listing standards have new definitions of "independence" for members of the Audit Committee. The NYSE definition is slightly different than that of the AMEX/NASDAQ, but each definition requires that:
- no committee member may have a business relationship with the company;
- no committee member may be an employee of the company or an immediate family member of an executive officer of the company; and
- there may be no cross-compensation committee link between any Audit Committee member and any executive of the company.
- Standards for Audit Committee Members. Effective June 14, 2001, the new listing standards of the NYSE, AMEX and NASDAQ mandate that all members of the Audit Committee be "financially literate" or become so within a reasonable time after appointment to the Audit Committee. In addition, the rules require that at least one committee member have financial expertise, defined as:
- past employment experience in finance or accounting;
- professional certification in accounting; or
- other comparable experience or background, such as CEO, CFO or other senior officer with financial oversight responsibilities.
- Report of Audit Committee in Proxy Statement. Beginning with each Proxy Statement for a shareholder meeting scheduled after December 15, 2000, the Proxy Statement must include a report of the Audit Committee. The SEC rules mandate the content of the report.
Reasons for the New Rules
The SEC and the exchanges believe new rules will improve disclosure about the functioning of Audit Committees and enhance the reliability and credibility of the financial statements of public companies. The new rules were adopted in response to continuing concerns about inappropriate "earnings management," where companies distort their financial performance in order to maintain positive earnings trends or meet financial analysts’ expectations. According to the SEC, additional disclosures about a company’s Audit Committee and its interaction with the company’s auditors and management will promote investor confidence in the integrity of the financial reporting process. The SEC also believes that a higher level of scrutiny by independent auditors of companies’ quarterly financial statements should lead to more reliable financial information about companies throughout the reporting year and, therefore, fewer year-end audit adjustments.
Quarterly Review by Auditors
Beginning with the first fiscal quarter ending on or after March 15, 2000, all public companies are required to have their independent auditors review each of the three quarterly interim financial statements to be filed on Form 10-Q (or Form 10-QSB) with the SEC. In their review, the independent auditors must use professional standards and procedures for conducting reviews, as established by generally accepted auditing standards. This means that the auditors must follow the procedures set forth in SAS 71, which is substantially less in scope than an audit and does not result in an auditor’s opinion regarding the financial statements taken as a whole. In connection with their quarterly review, the auditors must apply a series of analytical procedures to the financial data and must discuss matters such as any significant adjustments, management judgments and accounting estimates, significant new accounting policies and disagreements with management. If a company states in its Form 10-Q filing that the interim financial statements have been reviewed by its auditors, a report of the auditors on the review must be filed with the Form 10-Q.
The SEC has also expanded the scope of companies required to provide selected quarterly financial data in their Annual Reports. Previously, SEC rules required only large, widely held companies to include summary quarterly financial data. Under the new rule, all public companies with securities registered on a national securities exchange, with a few limited exceptions, must include these quarterly data. This requirement applies to all Annual Reports to Shareholders dated after December 15, 2000.
Audit Committee Charter
For each Proxy Statement for a shareholder meeting scheduled after December 15, 2000, all public companies must also disclose in its Proxy Statement whether its Audit Committee is governed by a charter, and, if so, include a copy of this charter as an appendix to the Proxy Statement at least once every three years. The Audit Committee is required to review and reassess the adequacy of the charter on an annual basis. During the review process, the Audit Committee should consider the detail included in the charter to avoid unnecessary disclosure and related legal exposure.
The SEC’s new rules do not require a company to adopt an Audit Committee charter or dictate the content of a charter if one is adopted. However, each of the NYSE, AMEX and NASDAQ has implemented revised listing standards that require an Audit Committee charter and dictate its content. By June 14, 2000, all companies listed on the NYSE, AMEX or NASDAQ must adopt a formal written Audit Committee charter and have it approved by the Board of Directors.
The Audit Committee charter must specify:
- the scope of the Audit Committee’s responsibilities and how it carries out those responsibilities, including structure, processes and membership requirements;
- the ultimate accountability of the company’s outside auditors to the Audit Committee and the full Board of Directors;
- the responsibility of the Audit Committee for ensuring the independence of the outside auditors; and
- the responsibility of the Audit Committee and the Board of Directors for selection, evaluation and replacement of the outside auditors.
All three exchanges’ new listing standards require that each Audit Committee must consist of at least three directors, comprised solely of independent directors as defined above.
Independence of Audit Committee Members
Proxy Statement Disclosure
Beginning with Proxy Statements for shareholder meetings scheduled after December 15, 2000, the SEC requires each company with listed or quoted securities to disclose whether each of the Audit Committee members is independent.
In only exceptional and limited circumstances, a company may appoint to its Audit Committee one director who is not independent. If a company chooses to make such an appointment, the Board of Directors must conclude that the membership of the individual on the Audit Committee is in the best interests of the company and its shareholders, and the company must disclose in its next Proxy Statement the reason the individual is not independent and the reasons for its determination to appoint the director to the Audit Committee.
The SEC also requires companies whose securities are not listed on the NYSE or AMEX or quoted on NASDAQ to disclose in their Proxy Statements whether, if they have an Audit Committee, the members are independent as defined in listing standards of the NYSE, AMEX or NASDAQ. While these companies are free to apply any of the three definitions of independence, they may adopt only one and must use it consistently to qualify all members of the Audit Committee.
Requirements for Independence of Members
Effective June 14, 2001, companies with securities listed on the NYSE or AMEX or quoted on NASDAQ must comply with the Audit Committee structure and membership requirements established by the applicable exchange. While these new listing standards are substantially similar to each other, the NYSE standards differ from those of the AMEX and NASDAQ in some respects. The NYSE adopted rules defining the independence of Audit Committee members, while the AMEX and NASDAQ adopted a new definition of "independent director" that applies to all directors, not just those serving on the Audit Committee.
Under the new listing standards, a director having any of the following relationships with the company will not be deemed to be independent.
- Employee. He or she is employed by the company or any affiliate in the current year or was employed during any of the past three years.
- Immediate Family Member. He or she has an immediate family member who is, or has been in any of the past three years, employed by the company or any affiliate as an executive officer. Immediate family includes a person’s spouse, parents, children, siblings, mother-in-law, father-in-law, brother-in-law, sister-in-law, and anyone who resides in that individual’s home.
- Business Relationship.
- (AMEX and NASDAQ) – He or she is a partner in, or a controlling shareholder or executive officer of, any for-profit business to which the company made, or from which the company received, more than 5% of the company’s or other business’ consolidated gross revenues for that year, or $200,000, whichever is more, in any of the past three years.
- (NYSE only) – He or she is a consultant to, partner in, controlling shareholder or executive officer of an organization that has had a business relationship with the company within the past three years. However, the Board of Directors may determine that the relationship does not interfere with his or her exercise of independent judgment. The Board of Directors must consider the materiality of the relationship when making this determination.
- Cross-Compensation Committee Link. He or she is an executive of another entity where any of the company’s executives is a member of the compensation committee.
- Material Compensation. (AMEX and NASDAQ only) He or she received more than $60,000 of compensation from the company or any affiliate during the previous year (other than director’s compensation).
Under all three exchanges’ new listing standards, each member of the Audit Committee must be "financially literate;" that is, able to read and understand fundamental financial statements or must become financially literate within a reasonable period of time after his or her appointment to the Audit Committee.
- The NYSE also requires that at least one member of the Audit Committee must have accounting or related financial management expertise as interpreted by the company’s Board of Directors in its business judgment.
- The AMEX and NASDAQ require that at least one member of the Audit Committee must have:
- past employment experience in finance or accounting;
- professional certification in accounting; or
- other comparable experience or background, such as CEO, CFO or other senior officer with financial oversight responsibilities.
- past employment experience in finance or accounting;
New Proxy Disclosure Requirements
Beginning with each Proxy Statement for a shareholder meeting scheduled after December 15, 2000, each public company must include in its Proxy Statement:
- a report of the company’s Audit Committee as to matters relating to the company’s financial statements and independent auditors;
- a copy of the Audit Committee’s charter at least once every three years; and
- disclosures regarding the independence of the Audit Committee members.
The Audit Committee’s report must state whether the Audit Committee has:
- reviewed and discussed the audited financial statements with management;
- discussed with the independent auditors the matters required by SAS 61 (regarding auditing standards), including a discussion of the auditor’s judgments about the quality (not just the acceptability) of the company’s accounting principles as applied to financial reporting;
- received the written disclosures and the letter from the auditors regarding their independence (as required by Independence Standards Board Standard No. 1) and discussed independence with the auditors; and
- based on its review and discussions referred to above, recommended to the Board of Directors that the company’s latest audited financial statements be included in the company’s Annual Report on Form 10-K (or Form 10-KSB) for filing with the SEC.
Safe Harbors – Addressing the Concern Over Liability of Members of Audit Committees
The SEC adopted "safe harbors" in the new rules to protect a company and its directors from the potential increase in directors’ liability from additional disclosure about the Audit Committee. Under the "safe harbors," the additional disclosure required by these rules would not be considered "soliciting material" or "filed" with the SEC (unless the company specifically requests that it be) and, accordingly, the disclosures will not be subject to the antifraud provisions of the Federal securities laws.
Conclusion
We recommend that each public company review the qualification of each of its directors to ensure their independence. If a director is found not to be independent or if the company does not currently have three independent directors, the company needs to begin the search for additional independent director(s).
Likewise, if any current or proposed member of the Audit Committee is not financially literate, we recommend that the company establish a process to allow that individual to become financially literate before the 2001 Proxy season or the individual’s election to the committee. The company also needs to make sure at least one director also has the requisite "financial expertise." If not, the company needs to begin the process of seeking to identify a suitable candidate with the requisite financial experience.
Most public company by-laws allow the Board of Directors to expand its size, thereby allowing the Board of Directors to appoint one or more directors to meet the new requirements in the year 2000 and nominate that director or directors for election by the shareholders at the 2001 Annual Meeting. Alternatively, the Board of Directors may simply nominate a new director for election at next year’s annual meeting. Companies should bear in mind that this meeting must be held prior to June 14, 2001.
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We would be pleased to provide you with further information about these new rules and answer your questions about them. Also, we would be glad to assist you in drafting your Audit Committee charter and in determining the "independence" of the company’s current directors and the financial literacy of the members of the Audit Committee.