Audit committees in corporate annual reports.

Events during 2001 and 2002, such as the bankruptcies of WorldCom and Enron and the criminal conviction of one of the "big five" accounting firms, Arthur Andersen, have exposed severe problems with the financial accounting and reporting system in the United States. The goal of high quality financial accounting and reporting requires that each of the major participants fulfill their responsibilities. For publicly traded corporations, these participants normally include the board of directors, the audit committee of the board, senior management, the internal auditor, and the outside independent auditor. The corporate audit committee is in a position to oversee the activities of management, the internal auditor, and the outside independent auditor. A properly functioning corporate audit committee is an essential component in the financial accounting and reporting system. The purpose of this article is to examine the development of audit committees including their composition, duties, and reporting requirements. This article will also disclose the status of reporting by audit committees that is currently occurring in the annual financial reports and proxy statements of the companies in the Standard and Poor's 100 Index.

DEVELOPMENT OF AUDIT COMMITTEES

Audit committees rose to prominence in 1978 when the New York Stock Exchange (NYSE) made it a requirement for the companies trading on the NYSE to have audit committees of their boards of directors.

National Commission on Fraudulent Financial Reporting

In 1987 the National Commission on Fraudulent Financial Reporting (Treadway Commission) stressed the importance of audit committees and urged the use of audit committee reports in corporate annual reports. In addition to discussing the audit committee report, the Treadway Commission described good practice guidelines for the audit committee. These guidelines were divided into three areas: general guidelines, selection of the independent auditor, and post-audit review. (1) The general guidelines address such things as the size of the committee. It recommended that the audit committee consist of at least three members, but not be so large that it prevents each member of the committee from being an active participant. The committee members should be outside independent directors of the board and their terms on the committee should be staggered. It was recommended that the audit committee meet on a regular basis and provide reports to the entire board of directors.

The audit committee should oversee the audits of the internal and external auditors. The audit committee should ensure that the two groups of auditors coordinate their audit plans and identify for the committee how their audit scope might lead to the detection of fraud or internal control weaknesses. The internal auditor and the independent public accountant should meet privately with the audit committee. If the independent public accountants intend to rely on the work of other independent auditors, the audit committee needs to insist their independent public accountants review the work of the other outside auditors. The audit committee must conclude that the use of the additional outside auditors is appropriate.

The audit committee should review the corporation' s internal policies concerning officers' expenses and use of company assets. Both the internal and independent auditors should be instructed to keep the audit committee informed of any areas they discover that would require special attention by the audit committee.

The selection of the independent public accountant is part of the good practice guidelines. The audit committee should review the proposed audit fee and the independent accountant s engagement letter. It should note the level of both audit partner and staff participation on the audit. If a successor independent accountant is chosen, the audit committee must review the steps to insure a smooth transition from predecessor to successor auditor. This review leads to the ultimate ratification of the independent accountant by the corporate stockholders. In addition, the audit committee should meet with the corporation's legal counsel to discuss legal issues that may have a material impact on the corporation's financial statements.

The Treadway Commission identified numerous steps that should be taken in a post-audit review, which is considered a very important part of the duties of the audit committee. Management's explanations for all significant variances in the financial statements between comparative years should be secured by the audit committee. The audit committee should identify any items that may materially affect the financial statements by making inquires of management. Significant reserves, accounting accruals, or estimates should be given special examination. The audit committee should then consider if the Management's Discussion and Analysis (MD&A) section of the corporate annual report is consistent with the data. Furthermore, the audit committee should inquire of both management and the independent public accountant if there were any changes in accounting standards that have an effect on the financial statements.

There should be a private meeting between the audit committee and the independent public accountant as part of the postaudit review. During these discussions the issues of the quality of the internal audit staff and of the corporate accounting and finance staff should be raised. In addition, the audit committee should inquire of the independent public accountant what were their greatest concerns on the audit and if they desire to discuss anything else that has not already been covered.

The management representation letter should be reviewed by the audit committee. The committee should inquire of the independent public accountant whether they experienced any problems in obtaining the letter or satisfactory coverage of issues addressed in the representation letter. Any contingencies, litigation, or other claims and assessments that either corporate in-house or outside lawyers raised during the audit should be discussed between the audit committee and the independent public accountant. How these legal issues were resolved or reflected in the corporation's financial statements should be determined by the audit committee.

The audit committee should review the MD&A section of the annual report with both management and the independent public accountant. The independent public accountant should be asked if the other information appearing in the annual report appears to be consistent with the financial statements. Finally, the audit committee and the board of directors must decide if the independent public accountant should come before the full board to answer any remaining questions.

The Treadway Commission officially called the audit committee report the audit committee chairman's letter. The specific components that should appear in the chairman's letter are presented in Figure 1. The guidelines for the letter are in general terms and allow substantial freedom and flexibility.

The Treadway Commission provided both practice guidelines and recommendations for reporting. The years that followed the establishment of these guidelines and recommendations did nor find many corporations wholeheartedly adopting them. The Audit Committee Chairman's Letter appeared in a very small number of annual reports. Most corporations discussed the functioning of the audit committee in their Report of Management. (2) It appeared corporations felt it necessary to discuss their audit committees in their corporate annual reports, but were unwilling to make this a thorough discussion in the form of an Audit Committee Chairman's Letter. There continued to be questions and concerns about the proper functioning of audit committees.

The stock exchanges require that directors serving on the audit committee be independent outside directors. This most commonly means that the director was not an employee of the company. It was soon noted that so-called "grey" area directors existed which would include relatives of management, consultants to the company, interlocking directors, and retired executives of the firm. Certainly these "grey" area directors could jeopardize the independent functioning of the audit committee. A recent study concluded that "audit committee independence increases with board size and board independence and decreases with the firm's growth opportunities and for firms that report consecutive losses." (3) In December of 1999 the NYSE and National Association of Securities Dealers Automated Quotations (NASDAQ) adopted new requirements that gave firms the option of including non-outside directors on their audit committees if it is in the firm's best interests to do so.

Blue Ribbon Committee on Improving the Effectiveness of Audit Committees

In 1998 a Blue Ribbon Committee on Improving the Effectiveness of Audit Committees (Blue Ribbon Committee) was established by the New York Stock Exchange and the National Association of Securities Dealers (NASD) to address some of the concerns expressed by the Securities and Exchange Commission (SEC) over accounting and reporting practices. The report and recommendations of the Blue Ribbon Committee were published in 1999 and had 10 major recommendations:

1. The NYSE and NASD adopt strict definitions of independence of directors serving on audit committees of listed companies.

2. The NYSE and NASD require larger companies to have audit committees composed entirely of independent directors.

3. The NYSE and NASD require larger companies to have "financially literate" directors on their audit committees.

4. The NYSE and NASD require each company to adopt a formal audit committee charter and to review its adequacy annually.

5. The SEC requires each company to disclose in its proxy statement whether it has adopted an audit committee charter as well as other information.

6. Each NYSE and NASD listed company state in the audit committee charter that the outside auditor is ultimately accountable to the board of directors and the audit committee.

7. All NYSE and NASD listed companies ensure their charters mandate that their audit committees communicate with the outside auditor about independence issues, in accordance with Independence Standards Board (ISB) regulations.

8. GAAS require that the outside auditor discuss with the audit committee the quality-nor just the acceptability-of accounting principles used.

9. The SEC require the annual report to include a letter from the audit committee clarifying that it has reviewed the audited financial statements with management as well as performed other tasks.

10. The SEC require the outside auditor to perform an interim review under SAS no. 71, Interim Financial Information, before a company files its form 10-Q.

Source: Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, New York, 1999, 10-16.

Public Oversight Board Panel on Audit Effectiveness

In response to SEC concerns about earnings management and deliberate efforts by management to misstate earnings, the Public Oversight Board, the independent private-sector body that oversees the activities of the SEC Practice Section of the American Institute of Public Accountants (AICPA), created a Panel on Audit Effectiveness in 1999. The Panel, frequently referred to as the O'Malley Panel, issued its report, "The Panel on Audit Effectiveness: Report and Recommendations," in August 2000. The report contained several recommendations directed to audit committees:

1. Increase attention to internal control, including obtaining a written report from management on the effectiveness of internal control

2. Evaluate entities' reserves and review activity in them with management and auditors

3. Develop a formal agenda of activities and have a minimum of two face-to-face meetings with the auditors (at least one in private) to discuss business risks, pressures on auditors, auditor performance, and any plans to hire audit firm personnel into high-level positions, among other topics

4. Request management to report on the entity's control environment and how that environment and the entity's policies and procedures serve to prevent or detect financial statement fraud

5. Ensure that management cooperates with the auditors in their efforts relating to detection of fraudulent financial reporting

6. Preapprove nonaudit services over a threshold amount determined by the audit committee, with consideration of criteria and factors suggested by the Panel

Source: The Panel on Audit Effectiveness: Report and Recommendations, Stamford, CT, 2000.

Securities and Exchange Commission Actions

The Treadway Commission, the Blue Ribbon Committee, and the O'Malley Panel were persuasive bodies that encouraged corporations to implement their recommendations. The SEC is a regulatory body that sets regulations that corporations must follow. On December 15, 2000, the SEC issued a regulation that required companies to provide a report from their audit committee in their proxy statements. The report was to disclose whether the committee has recommended that a company's audited financial statements be filed with the SEC. Companies must also disclose in their proxy statements whether the audit committee has a written charter which specifies the committee's duties. This charter would need to be submitted to the SEC every three years. (4)

The SEC also approved new listing standards for the NYSE, the American Stock Exchange, and the NASDAQ Stock Market that require the companies to disclose whether their audit committee members are independent of management. The exchanges would require audit committee members to have some financial expertise. (5)

AUDIT COMMITTEE DISCLOSURES IN CORPORATE ANNUAL FINANCIAL REPORTS AND IN ANNUAL PROXY STATEMENTS

The 100 public companies that comprise the Standard and Poor's 100 Index were selected to be examined for audit committee disclosures. The annual financial reports or forms 10-K and proxy statements for the year 2001 were obtained and examined for the 100 companies for this project. The list of disclosure items was developed from the SEC requirements and recommended practices from the Treadway Commission, the Blue Ribbon Commission, and the O'Malley panel.

Disclosures in the Annual Report

Audit committee disclosures within the annual financial report are generally made in the Report of Management although there were two companies that used a separate Audit Committee Letter to discuss the activities of the audit committee. Most of the companies (80%) used the Report of Management to discuss audit committee activities; however, 20% of the companies did not have a Report of Management and did not discuss audit committee activities within their annual reports. Table 1 presents the findings from the examination of the annual financial reports with the percentages calculated using the 80 companies that had a Report of Management or Audit Committee Letter as the population.

Report of Management was the most frequently used heading; however, Management's Discussion of Financial Responsibility and Management's Responsibility for Financial Statements were headings used by a few companies. For those companies that had the Report of Management or a separate audit committee letter, the audit committee met with management and the independent auditors in 78 companies, which represents 96% of the companies. The audit committee met with the internal auditors in 87% of the companies. The independent auditors had free access to the audit committee in 82% of the companies while the internal auditors had free access to the audit committee in only 70% of the cases. The results reflect substantial compliance with the guidelines, the lower percent associated with free access of the internal auditors to the audit committee should be considered a problem.

Disclosures in the Proxy Statement

The annual proxy statements typically present the greatest amount of audit committee disclosures for users. There are normally two audit committee disclosures in all proxy statements: a general description of the audit committee composition and responsibilities as part of the description of all board of directors' committees and the Audit committee report. The general description presents what the audit committee is supposed to do and the audit committee report presents the actual accomplishments of the audit committee during the year. The third item that appears in the proxy is the written Audit Committee Charter. Currently companies need to include the Audit Committee Charter in the proxy statement whenever it is modified, but must include it once every three years. This research project was primarily interested in the audit committee disclosures that are made each year and thus did not include an analysis of the audit committee charters.

This research was able to examine the proxy statements for all of the companies, the percentages in Tables 2, 3, and 4 are based on 100 companies. Table 2 indicates the number of members on audit committees as disclosed in the proxy statement. Although the range of number of members is from three to a seemingly unwieldy eleven, 85 companies have audit committees consisting of three to six members. All companies appear to have an adequate number of audit committee members and only 15 companies had seven or more members on the committee.

Table 3 discloses the number of times that the audit committee met during the year. While the range of the number of meetings is from one to more than ten, 68 companies' audit committees met from 4 to 7 times during the year. There were only 2 companies whose audit committee met fewer than three times during the year. The audit committee of one company met 13 times during the year. This company was involved with restatement of prior years' results and an SEC investigation, thus it was not an unexpected result.

Table 4 lists ten detail disclosure items that were made in the proxy statement. All the members of the audit committee were identified as meeting the independence criteria by 97% of the companies. Only three companies stated that the audit committee members were financially literate. Although 100% of the companies stated their audit committees met with management and the outside independent public accountant, only 54% of the audit committees met with the internal auditor. Almost all (99%) companies had audit committees that met the requirements of Statement on Auditing Standards 61 (SAS61) and referred to auditor independence as required by Independence Standards Board 1 (ISB 1). Ninety one percent of the companies made reference to their written audit committee charters and 98% of the audit committees stated they had considered the nonaudit services performed by the independent public accountant. All the companies' audit committees recommended that the financial statements be filed in Form 10-K with the SEC . The recommendation of the independent public accountant was made by 95% of the audit committees. One company that had been using Andersen stated they were not ready to recommend the outside public accountant at the date of the proxy. There were 8 companies that included cautionary statements about the responsibilities and duties of the audit committee.

CONCLUSION

With the large number of prominent corporate frauds, the importance of properly functioning audit committees rises. The audit committee is in the unique position to oversee the activities of corporate management, the internal auditors, and the independent public accountant to insure that the firm's financial statements are fairly presented. This article examined the development of the audit committee and determined the current disclosure practices of the audit committees of the companies in the Standard and Poor's 100 Index.

While the findings of this project indicate generally high levels of compliance with the disclosure guidelines, there continues to be a number of companies reporting earnings restatements. These events appear to confirm the urgent need for better guidelines.

POSTSCRIPT 

Congress passed and the President signed into law the Sarbanes-Oxley Act of 2002 on July 31, 2002. This act revises and adds to the duties and responsibilities of audit committees. The act makes clear that independent auditors are to report to and be overseen by a company's audit committee, not company management. All nonaudit services provided by the independent outside auditor must be preapproved by the audit committee and disclosed to investors in periodic reports. While the Sarbanes-Oxley Act increases the duties and responsibilities of audit committees, it remains an open question whether sufficient changes have been made.

FIGURE 1. Good Practice Guidelines for Audit Committee Chairman's Letter

1. The composition of the audit committee.

2. The identity of each audit committee member, unless disclosed elsewhere.

3. The audit committee's purpose, objectives, and responsibilities.

4. The activities of the audit committee during the past year, including matters such as the number of meetings held and significant topics discussed with management, internal auditors, and independent public accountants.

Source: National Commission on Fraudulent Financial Reporting, Report of the Commission on Fraudulent Financial Reporting. Washington, D.C., 187.

TABLE 1

Annual Report Disclosures

Audit Committee Activity          Percentage Complying

Audit committee has met with               96
 management and the independent
 auditors
Audit committee has met with               87
  the internal auditors
Independent auditors have access           82
 to the audit committee.
Internal auditors have access to           70
 the audit committee

TABLE 2

Number of Members on Audit Committees

Number of Members       Percentage

  Three or Four             42
  Five or Six               43
  Seven or Eight            11
  Nine, Ten, or Eleven       4

TABLE 3

Number of Audit Committee Meetings

Number of Meetings  Percentage

  One or Two            2
  Three or Four        40
  Five or Six          28
  Seven or Eight       19
  Nine or Ten           8
  More than Ten         2

TABLE 4

Audit Committee Disclosures in the Proxy Statement

Disclosure Items                                        Percentage

All members are identified as being independent
 diectors                                                       97
Members are identified as being financially literate             3
Audit committee met with management and the external
 auditors                                                      100
Audit committee met with internal auditors                      54
Audit committee met SAS 61 requirements                         99
Reference to auditor independence as required by ISB 1          99
Reference to written audit committee charter                    91
Considered nonaudit services                                    98
Recommended financial statements to be filed in Form
 10-K                                                          100
Recommended appointment of outside auditors                     95

(1.) National Commission of Fraudulent Financial Reporting, Report of the National Commission on Fraudulent Financial Reporting, Washington D.C., 1987, 179-81.

(2.) Kintzele, Marilyn R., "The Use of Audit Committee Reports in Financial Reporting," Internal Auditing 6(4): 16.

(3.) Klein, April, "Economic Determinants of Audit Committee Independence," The Accounting Review 77(2): 435.

(4.) "SEC to Adopt New Financial-Reporting Rules," Wall Street Journal, December 16, 1999.

(5.) Ibid.

REFERENCES

BLUE RIBBON COMMITTEE ON IMPROVING THE EFFECTIVENESS OF CORPORATE AUDIT COMMITTEES. "Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees," New York, 1999.

CARCELLO, JOSEPH V., AND TERRY L. NEAL. "Audit Committee Composition and Auditor Reporting." The Accounting Review vol. 75, no. 4 (October 2000): 453-67.

KINTZELE, MARILYN R. "The Use of Audit Committee Reports in Financial Reporting." Internal Auditing, vol. 6, no. 4, (Spring 1991): 16-24.

KLEIN, APRIL. "Economic Determinants of Audit Committee Independence." The Accounting Review, vol. 77, no. 2 (April 2002): 435-52.

NATIONAL COMMISSION ON FRAUDULENT FINANCIAL REPORTING. Report of the National Commission on Fraudulent Financial Reporting. Washington, D.C., 1987.

PUBLIC OVERSIGHT BOARD. The Panel on Audit Effectiveness: Report and Recommendations. AICPA, August 2000.

READ, WILLIAM J., AND KANNAN RAGHUNANDAN. "The State of Audit Committees." Journal of Accountancy, May 2001: 5 7-60.

VICKNAIR, DAVID, KENT HICKMAN, AND KAY C. CARNES. "A Note on Audit Committee Independence: Evidence from the NYSE on 'Grey' Area Directors." Accounting Horizons, vol. 7, no. 1 (March 1993): 53-57.

WALL STREET JOURNAL. "SEC to Adopt New Financial Reporting Rules." December 16, 1999.

ZACHARIAS, CAROL A. "New Rules, New Responsibilities." Journal of Accountancy, August 2000: 53-55.