Auditing


Audit Committee Rules to Improve Disclosure

To address earnings management concerns raised by SEC Chairman Arthur Levitt, Jr., the National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE), the American Stock Exchange (Amex), the auditing standards board (ASB) and the SEC itself individually adopted rules and standards focusing on the composition and activities of audit committees. Regulators and standard setters hope the rules will improve the quality of financial reporting and make it harder for corporations to manipulate the data on which their reported earnings are based. The rules take effect on various dates—some as early as March 2000, but none later than June 2001.

Levitt supplied the impetus for the new rules in a September 1998 speech (“Arthur Levitt Addresses ‘Illusions,’” JofA , Dec.98, page 12) that warned of a “gray area where accounting is being perverted” in order to “make the numbers.”

Amy A. Ripepi, an auditing partner in the Chicago office of Arthur Andersen LLP, said Levitt “addressed his remarks to audit committees, auditors and standard setters because he believed they all needed to step up to the plate and do a better job of executing their respective responsibilities.”

But because several bodies share oversight of audit committees and their work, Ripepi explained, the regulators and standard setters planned and established new requirements across a diverse jurisdictional landscape. “The SEC has jurisdiction over reporting of information to the public, so it enacted rules requiring audit committees to report [as part of the proxy statement] on how they handle their responsibilities.

“But the SEC doesn’t have jurisdiction over corporate governance,” Ripepi noted. Instead, each stock exchange has its own listing requirements, some of which pertain to corporate governance, for companies whose securities are traded on it. “That’s why the proposals to require audit committee members to be independent, to have a certain number of members and for them to be financially literate were handled through the exchanges,” she added.

In issuing its rules, the SEC said audit committees are best qualified to oversee the participation of corporate management and independent auditors in the financial reporting process. So, one of its rules requires audit committees to advise investors, in a report included in the proxy statement, whether they have reviewed and discussed the audited financial statements with management, conferred with the auditors on matters required to be deliberated by SAS no. 61, Communication With Audit Committees, and received from the auditors disclosures regarding their independence as required in ISB Standard no. 1, Independence Discussions with Audit Committees (see JofA , Apr.99, p. 102), and discussed it with them. The rule further requires that audit committees specify in the proxy statement whether they had recommended the company’s audited financial statements be included in its annual report to the SEC. Audit committees also must maintain a written charter specifying their duties and file a copy of it with the SEC every three years. Proxy statements relating to shareholder votes after December 15, 2000, will be subject to the rule.

Another SEC rule requires independent auditors to review companies’ interim financial statements (Forms 10-Q and 10-QSB) before they are filed with the commission; the rule became effective for fiscal quarters ending on or after March 15, 2000.

Some of the increased disclosure provisions stirred significant controversy as soon as the SEC proposed them. In response, the commission provided “safe harbors” in certain areas, but not all. With respect to the requirement that audit committees provide some sort of assurance on the quality of a company’s financial statements, the SEC said increased disclosure could actually result in fewer liability claims alleging audit committee members had breached their fiduciary duty. Nevertheless, the commission reduced the proposed level of assurance required of audit committee members, who cannot be assumed to be qualified, for example, to say whether financial statements were prepared in accordance with GAAP.

The SEC also approved new standards of its own that are based on NYSE, Amex or NASD listing requirements for public companies. One SEC provision stipulates that these companies must disclose whether management exerts any influence over audit committees that would compromise their independence. NYSE-listed companies whose audit committee members satisfy current NYSE rules will be deemed in compliance until their members are reelected or replaced. Those listed on the Amex or quoted on the NASDAQ will be deemed in compliance until their members’ current terms expire, but not past June 2001, when the transition period ends. All companies whose audit committees consist of one or two members will have until June 2001 to increase their size to three members.

The ASB provided guidance relating to communication between independent auditors and audit committees. Its SAS no. 90, Audit Committee Communication, (see JofA , Mar.2000, p.103) requires that independent auditors obtain from audit committees their opinion of the quality, not just the acceptability, of the accounting principles applied in the company’s financial reports. In addition, the SAS requires an independent auditor to discuss with an audit committee certain issues before a company files a form 10-Q and preferably before it publicly announces its financial results. SAS no. 90 became effective for reviews of interim financial statements for periods ending on or after March 15, 2000.

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