NYSE Sets Audit Committees on New Road

It’s no longer business as usual for audit committee members and auditors.


THE NEW YORK STOCK EXCHANGE HAS PROPOSED NEW standards for its listed companies to compel audit committees to change their makeup, broaden their oversight of external auditors and assume greater responsibility for their fiduciary obligations. The audit committee would have the sole authority to retain and terminate the company’s independent auditors and to approve an audit engagement’s fees and terms.

BECAUSE EACH MEMBER OF AN AUDIT committee would have to be financially literate, and at least one committee member would need to have accounting or related financial management expertise, CPAs could showcase their knowledge and skills and contribute to an improved corporate culture by agreeing to serve on audit committees.

COMPANIES LISTED ON THE NYSE must continue to have an audit committee composed of a minimum of three independent directors. The proposed rules require certain individuals to observe a five-year “cooling-off” period before they can serve on a corporate board and meet the independence requirements.

DIRECTORS’ FEES Would BE THE ONLY COMPENSATION that an audit committee member could receive from the company. The existing NYSE rules for audit committees contain no such mandate.

AUDIT COMMITTEES WOULD HAVE TO HAVE SEPARATE sessions with management, external auditors and those responsible for internal audit. The NYSE would require all listed companies to have an internal audit function. Companies could outsource this task to an entity other than its independent auditor.

PAUL SWEENEY is a freelance writer in Brooklyn, New York. His e-mail address is pswe865002@aol.com . CYNTHIA WALLER VALLARIO, JD, is a senior editor on the JofA . Ms. Vallario is an employee of the AICPA. Her views, as expressed in this article, do not necessarily reflect the views of the Institute. Official positions are determined through certain specific committee procedures, due process and deliberation.

eadline-grabbing accounting scandals such as the ones at WorldCom, Adelphia Communications, Global Crossing and, of course, Enron cost investors hundreds of millions of dollars and thousands of employees their jobs. Corporate financial executives, internal auditors, audit committee members, external auditors—and all accounting professionals—need to be aware of the new corporate governance rules the New York Stock Exchange (NYSE) has proposed to help the audit committees and external auditors of companies listed on the Big Board address the weaknesses that led to accounting and corporate reporting failures.

As CPAs study and prepare to work with the proposed standards, which will provide better checks and balances for companies’ financial reporting and audit oversight, they will have opportunities—as auditors in relationships with audit committees and as corporate governance advisers in both audit and nonaudit engagements—to help those companies evaluate their audit committee practices, effect improvements where necessary and promote policies to provide value for shareholders. And perhaps most important—because each member of an audit committee must be financially literate and at least one committee member must have accounting or related financial management expertise—CPAs can showcase their knowledge and skills, and contribute to an improved corporate culture, by agreeing to serve on these committees.

On August 1, 2002, the NYSE’s board of directors approved amendments to its listing standards and filed the proposed rules with the SEC on August 16; a public comment period must elapse before the commission votes and gives its final approval. The proposed rules are aimed at restoring investor confidence by enhancing company accountability and strengthening corporate governance. A key provision in the NYSE amendments would make a company’s audit committee responsible for oversight of external auditors and give it sole authority to approve all audit engagement fees and terms, as well as all significant nonaudit engagements for the outside auditors. (The text of the proposal is available at www.nyse.com .) The amendments, which also include requirements for public companies and their directors that go beyond those aimed at audit committees, would appear in the NYSE manual for listed companies under “Corporate Governance Standards” (as new section 303A). In the meantime the Nasdaq filed rules similar to those of the NYSE and also awaits SEC approval. (For information on related regulations from Congress and the SEC, see “ Regulations Under the Sarbanes-Oxley Act, JofA , Oct.02, page 33.)

The proposed standards would affect all companies whose stocks trade on the NYSE and also business organizations in noncorporate forms, such as limited partnerships, business trusts and REITs (real estate investment trusts), subject to the exchange’s jurisdiction. Existing audit committee requirements would apply during the transition to the new rules.

The proposed rules broaden the audit committee’s authority with respect to the integrity of a company’s financial statements and the independence of outside auditors—even though the audit committee does not certify the financial statements or guarantee the external auditor’s report. Two significant requirements in the proposed NYSE listing standards address the independence of corporate boards of directors, from whose ranks the audit committees are drawn, and fee payment to audit committee members.

Public Fed Up With Corporate Scandals

Public confidence in the reliability of companies’ reported earnings reached historic lows, with 79% of Americans telling pollsters at CBS News in July that “questionable accounting practices are widespread.” The survey also revealed two-thirds of the respondents believed corporate executives were not honest.

Source: CBS News Poll, July 2002, www.cbsnews.com .

A redefinition of the “independence” requirement. The board of a listed company would be required to have a majority of independent directors, but all the members of the board’s audit committee would have to be independent. (The audit committee would continue to have a minimum of three members.) The exchange tightened its definition of independent director: For an individual to qualify as independent, a company’s board of directors must affirmatively determine he or she has no material relationship with the listed company either directly or as a partner, shareholder or officer of an organization that has a relationship with the company. Material relationships can include commercial, banking, accounting, legal, consulting, industrial, charitable and familial relationships. A board must disclose in the company’s annual proxy statement how it determined a relationship was not material and may disclose the standards it used to judge independence. (The existing NYSE definition of independence precludes only any relationship with the listed company “that may interfere with the director’s exercise of independence from management and the company.”)

To satisfy the independence requirement, certain individuals would have to observe a stricter and broader “cooling-off” period before serving on a company’s board in any capacity: five years for former employees of the listed company, employees of its present or former external auditor, former employees of any company whose compensation committee included an officer of the listed company and immediate family members in any of these categories. The existing cooling-off period is three years and applies only to former employees of the listed company.

Controlled companies (one in which an individual, a group or another company hold more than 50% of the voting power) would have to have a completely independent audit committee but would be exempt from the requirement that a board must have a majority of independent directors.

Fees for audit committee members. Directors’ fees would be the only compensation audit committee members might receive from the company. Existing NYSE rules for audit committees have no such mandate. The increased responsibilities placed on audit committees would involve a significant time commitment; therefore the audit committee members could receive more compensation than other board directors. Audit committee members might receive their fees in cash or company stock, options or other consideration ordinarily available to directors. As long as an audit committee member satisfied the definition of independence, then receipt of a pension or other form of deferred compensation from the company for prior service would not preclude him or her from complying with the “directors’ fees only” compensation requirement.

Examples of compensation audit committee members could not accept under the proposed standards include fees paid directly or indirectly for services as a consultant or legal or financial adviser and compensation paid to a director’s business for consulting or advisory services even if he or she did not provide the actual service. However, disallowed compensation would not include ordinary compensation paid in other customer or supplier or business relationships that the board already had determined were not material for purposes of assessing a director’s independence.

The proposed NYSE standards would require audit committees to fulfill their responsibilities by performing certain tasks. Each audit committee must

Draft a written charter. An audit committee must have a written charter that addresses the committee’s purpose—that is, to assist board oversight with respect to the integrity of the company’s financial statements, compliance with regulatory and legal requirements, the qualifications and independence of the external auditors and the performance of the company’s internal and external audit functions. The audit committee may obtain input from management but cannot delegate to it these responsibilities. Thus the audit committee is directly responsible for the appointment, compensation and oversight of external auditors who in turn must report directly to that committee.

Review the external auditor’s report. At least annually the audit committee must review the external auditor’s report describing the company’s internal control procedures, any issues arising from independent audits or regulatory investigations by governmental authorities and all relationships the audit firm has with the company. Also the audit committee must assure the rotation of the lead audit partner as required under federal law. To safeguard auditor independence, the committee also should consider the need for a regular rotation of the audit firm and report its findings to the full board of directors.

Discuss annual and quarterly financial statements. The audit committee must meet with management and the independent auditor to review audited annual and quarterly financial statements, including the company’s disclosures under management’s discussion and analysis (MD&A) of financial condition and operations. The committee may discuss earnings releases and earnings guidance in general, such as the type of presentation the company should make for quarterly earnings statements. It is not required to discuss in advance of publication each earnings release or each instance in which a company may provide earnings guidance to the public. (For more information about earnings releases, see “Hazy Reporting,” JofA , Aug.02, page 47.)

Arrange meetings with management, internal auditors and independent auditors. To perform its oversight functions the audit committee must have separate sessions with management, those responsible for internal audit and external auditors. The NYSE rules would require all listed companies to have an internal audit function. This does not mean every company would have to establish a separate internal audit department. Companies might outsource this task as long as it’s to an entity other than its independent auditor.

Assess risk management. While the CEO and senior management are responsible for their company’s risk exposure, the audit committee must discuss with the internal and external auditors how the company handles major financial risks and the steps taken, within its guidelines and policies, to monitor and control exposures to such risks. If a company has in place an oversight committee responsible for risk management, as well as other control mechanisms, then the audit committee should review these processes but need not substitute itself as the risk authority.

Review any audit problems and management’s response. The audit committee must regularly review with the external auditor any difficulties encountered in the course of the audit, including any restrictions on the scope of the auditor’s activities or access to requested information or any significant disagreement with management. Some items the audit committee may want to specifically review are accounting adjustments noted or proposed by the auditor but viewed as “immaterial” by management, communications between the auditor and the audit firm’s national office regarding auditing or accounting issues that arose in the engagement and any “management” or “internal control” letter issued, or proposed to be issued, by the audit firm to the listed company.

Promote sound hiring policies for audit firm employees. While employees of audit firms can be valuable additions to a company’s management, the audit committee should establish hiring policies governing such employment, taking into account the pressures for auditors seeking a position with the company they audit. (Audit committees should be aware of the following prohibition with respect to employment of former auditors in section 206 of the Sarbanes-Oxley Act of 2002: If a company’s CEO, CFO, controller or chief accounting officer had been an employee of an audit firm and had worked on the company’s audit, that firm may not provide audit services to the company for one year.)

According to a spokesperson for the NYSE, when the SEC approves the standards, the exchange plans to hire additional employees to monitor companies’ compliance. (For information on implementation, see the timetable at right.) The sanctions the NYSE might impose on companies for failing to abide by these rules include issuing a public reprimand letter, suspending trading of the company’s shares or delisting a company’s stock from the exchange.

So what happens next? Audit committees can no longer be complacent—they face scrutiny and pressure from a roused Congress, the SEC, irate investor groups, major stock exchanges and an alarmed public. Were many of the recent accounting scandals set in motion because audit committees were asleep at the switch? “Everyone has recognized for some time that audit committees are not as effective as they should be,” says Philip Livingston, CPA, president and CEO of Financial Executives International (FEI) in Morristown, New Jersey. Anyone examining recent cases of corporate misconduct, adds Livingston, “will find it all comes down to a governance failure of one sort or another. We’ve let our guard down.” “Audit committees are going to have to start rocking the boat,” says Dan M. Guy, CPA, of Santa Fe, New Mexico, and formerly AICPA vice-president for professional standards and services. “The buck stops here—with the audit committee,” he says. As a start potential directors should do some homework: Ask questions about the external auditor, other committee members and the internal audit staff before joining a board.

Timetable for Listed Companies to Implement NYSE Provisions

Within 6 months following SEC approval

Increase audit committee authority and responsibility over external auditors.

Adopt the required audit committee charter.

Establish an internal audit function.

Adopt corporate governance guidelines and a code of business conduct and ethics.

Within 24 months following SEC approval

Have a majority of independent directors on boards and apply independence qualification standards to audit committee members.

Within 24 months of initial listing

Comply with board and audit committee independence criteria; a company transferring from another market would have 24 months from the date of transfer to comply if other market did not have the same requirements.

Individuals serving on audit committees now will find possessing the harder-to-define qualities of honesty and “good moral character” more important than ever, say corporate governance experts. Thus, to recruit persons for audit committees, boards should look beyond just high-profile names, says CPA Olivia F. Kirtley, former chairperson of the AICPA board of directors and also former CFO at Vermont America Corp. in Louisville, Kentucky. “The audit committee of the future will have more people from the CPA profession,” asserts Kirtley. “Everyone realizes how complex this work is. You have to ask the right questions and judge the adequacy of the answers. The committee can’t have just the chairperson doing that. CPAs and CFOs need to step up and raise their visibility.”

With the NYSE’s new definition of independence, directors must discard the clubby, “friends of the CEO” atmosphere. New faces in corporate boardrooms increasingly belong to people who worked as CFOs, says Gayle Mattson, a vice-president at executive search firm Korn Ferry International in New York, which also places directors. The most sought after people, she says, are current or former CEOs with CFO experience, plus executives who ran companies after service as a partner at a top accounting firm. Companies are closely examining the qualifications of individuals on board committees. “For the first time they are bringing in new directors for the specific purpose of sitting on the audit committee,” says CPA Richard Steinberg, who is corporate governance leader at PricewaterhouseCoopers in Florham Park, New Jersey, and head of the firm’s practice on advising audit committees of major companies.

The NYSE originally planned to require the audit committee chairperson to have accounting or related financial management expertise. But as the result of a provision in the Sarbanes-Oxley Act specifying that at least one member of the audit committee qualify as a “financial expert,” the exchange chose instead to wait for the SEC’s interpretation of the definition. FEI’s Livingston thinks requiring the audit committee chairperson to have financial management experience could be “a terrific and powerful step forward,” but he would like more attention paid to the skill levels of other members on the audit committee. “The definitions of financial literacy and expertise,” he says, “frankly, are not tough enough.” FEI would like to see criteria for the “financial expert” include an understanding of GAAP and experience in both the preparation and the auditing of financial statements for companies similar to the one on which the audit committee member serves and in the internal governance and procedures of audit committees. A person might gain such experience, for example, by working as the lead external auditor on a company’s audit engagement.

“Requiring independence is key to the success of the audit committee’s function,” says Charles Elson, a University of Delaware law professor in Newark, Delaware, who currently serves on the boards of directors and audit committees of several Fortune 500 companies, including Sunbeam and AutoZone. He agrees with the NYSE’s decision to require compensation for audit committee members only in the form of directors’ fees and long-term stock ownership, without any other ties. Independence is crucial for several reasons, Elson adds; it not only reduces conflicts of interest but assures external auditors have a place to turn when they have questions or concerns about, for example, the numbers management feeds them. “The fear now is that they (external auditors) don’t always get a good sounding board,” he says.

Kirtley—who heads audit committees at ResCare in Louisville, Kentucky; Alderwoods Group in Toronto; and Lancer Corp. in San Antonio, Texas—says the audit committees she serves on all meet more frequently—as many as seven or eight times each year rather than the four or five meetings in the past. “We have to meet with regard to quarterly earnings, as well as when other substantive issues arise,” she says. Audit committees already are seeking advice from outside experts with greater regularity, says Kirtley, to counterbalance the information management and external auditors provide. Despite her own strong background in financial management, Kirtley now is likely to seek outside assistance when new and complex issues arise. “It’s not that you don’t trust the people sitting before you, but there can be several interpretations on something such as an international tax question,” she says.

Similarly, Barbara Hackman Franklin of Washington, D.C., a former Secretary of Commerce who heads the audit committees of Aetna and Dow Chemical, says she, too, is less willing now to rely only on internal and external auditors’ reports. In one recent instance, she says, a question arose over impairment of goodwill that involved a write-down on the balance sheet. “In the past,” says Franklin, also a former public member of the AICPA board of directors, “we would have approved the write-down without hesitation because the company had obtained a fairness opinion. Instead, “we wanted to see what was behind the numbers, so we asked to take a look at the workpapers. Before the Enron scandal we wouldn’t have probed as much.”

The NYSE’s proposed new standards would alleviate some concerns about audit committee members’ sufficiency of financial expertise by ensuring they can go outside for independent accounting, legal or management advice—without first having to ask the company’s board of directors. Some critics, such as accounting professor Douglas R. Carmichael, CPA, of Baruch College, New York City, hope to see something more: a full-time, independent accounting expert working for the audit committee. He says audit committees were at the mercy of the two groups they were supposed to be overseeing—management and independent auditors—and as a result they didn’t ask probing questions or they got superficial answers.

While most experts think obtaining outside advice helps an audit committee carry out its duties, having a full-time CPA in the employ of the committee represents a minority view. Moreover, once standards from the NYSE and other regulators take effect, the audit committee may find the external auditor playing the role of independent adviser that Carmichael envisions. That is the view of Robert Kueppers, CPA and Deloitte & Touche partner in Wilton, Connecticut, who heads the AICPA SEC practice section’s executive committee. “In terms of the way they function, auditors will now work directly for the audit committee. It, not company management, will hire and fire the auditors and determine their pay,” says Kueppers.

Audit committee members and their CPA advisers say the new political environment has many of them exercising greater care and working harder on their own. Diane C. Harris, president of Hypotenuse Enterprises, a mergers and acquisitions consultant in Rochester, New York, serves as chairperson of the audit committee at Dallas-based FlowServe Corp., a maker of oilfield pumps and other equipment. She says her audit committee is more absorbed in audit’s nitty-gritty than ever before. “It doesn’t mean you lose sight of the big picture, but you can’t be above the details,” says Harris.

Audit committees soon may find themselves burdened with so many tasks, such as ensuring a company complies with all legal and regulatory requirements, they will be unable to fulfill their primary mission of overseeing the financial reporting process. “I am seeing more and more responsibility thrust on audit committees,” says Steinberg. “Some corporate boards expect audit committees to be responsible for oversight of ethics, internal controls over nonfinancial information and risk management on a broad basis and also to conduct special investigations,” he says. Guy agrees with Steinberg. “We shouldn’t saddle them with so much work that they can’t perform their ‘real’ role,” says Guy.

Since an audit committee, in the language of the NYSE’s rule filing with the SEC, “stands at the crucial intersection of management, independent auditors, internal auditors and the board of directors,” it is a logical place for investors to assign blame. “Audit committees are clearly in the hot seat,” says Patrick McGurn, vice-president at Institutional Shareholder Services, a research organization for institutional investors in Bethesda, Maryland. “There barely is a case of ‘Enronitis’ that doesn’t involve accounting issues, and that brings the problem back to the audit committee,” he adds.

Is there a way to ensure the accountability of audit committees? Professor Carmichael thinks audit committees need more stringent guidelines, including greater disciplinary measures from regulators for laxity or malfeasance. Citing the example of Enron’s audit committee chairman, Carmichael says, “For a person of his background and position not to have spotted problems and to have acquiesced with management without raising his voice is unconscionable.” A step in the right direction, he says, is the new authority the SEC has to permanently bar certain individuals from serving as corporate directors and officers.

Since the NYSE and Congress have begun to change the game plan for audit committees and external auditors, audit committees will wield a much bigger stick. As they are given more authority and responsibility, committee members can be expected to exercise those prerogatives. It’s possible that in the future no one will question that audit committee loyalties lie with shareholders.


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