Corporate accountability reforms create new challenges for audit committees.

The audit committee's charge to effectively oversee the integrity of the financial reporting process has become an imperative of the capital markets in the wake of the widespread changes affecting corporate governance. These changes have placed a direct and sharpening focus on audit committee members, whose role as guardians of investors' interests now brings greater exposure and more demanding expectations-and requires more commitment than ever.

Corporate accountability reforms have taken center stage in the United States due to a number of high-profile financial reporting failures and restatements. The reaction of the investing public and regulators resulted in the landmark Sarbanes-Oxley Act of 2002, as well as new U.S. Securities and Exchange Commission (SEC) regulations and listing standards from the major U.S. stock exchanges, including the NYSE and the Nasdaq Stock Market, Inc. (NASDAQ).

These changes are the most far-reaching securities reforms to be enacted in nearly 70 years and are meant to restore the public's trust in the capital markets, corporate management, corporate directors and the professionals who serve them. The reforms have broadly redefined and reemphasized the roles, responsibilities and accountabilities of all participants in a company's financial reporting process: management and internal audit; the board of directors, including the audit committee; and the external auditor.

In particular, the members of the audit committee must be more focused than ever on enhancing the effectiveness of their committee to meet the expanding scope of activities it must manage.

Embracing Change

As stated earlier, the new corporate accountability reforms represent some of the most sweeping changes ever to affect the board and audit committee. Some of the more significant changes include:

* New rules concerning audit committee member independence (stock exchanges):

* Disclosure of the name of the "audit committee financial expert," or if one does not exist, why not (Sarbanes-Oxley and see);

* Direct responsibility for the oversight of the external auditor including its appointment, retention and compensation (Sarbanes-Oxley);

--Pre-approval of audit and non-audit services:

--Resolution of disputes between management and the external auditor;

* Discussion of risk assessment and risk management policies set by management (NYSE);

* Oversight of legal and regulatory compliance (NYSE);

* Additional communications from management regarding internal controls and any instances of fraud involving management or other employees with a significant role in internal control (Sarbanes-Oxley);

* The establishment of a "whistleblower" communication process (Sarbanes-Oxley);

* Corporate Governance Guidelines must address director orientation and continuing education (NYSE).

These new roles, responsibilities and activities can cause audit committees to feel more "empowered," which can sometimes result in friction between the audit committee and management.

Redefining Roles

Following the 1999 report of the Blue Ribbon Committee, new audit committee membership listing standards were issued. The standards require each public audit committee to have at least three independent, financially literate directors and at least one member who had "financial expertise." Financial literacy is broadly defined as "the ability to read and understand basic financial statements," and the definition of "financial expertise," although more stringent, is also fairly general.

Boards of directors are now taking a much closer look at the makeup of the audit committee, considering not only whether the members have the right background, but also any relationship that might suggest something other than a completely independent mindset. As a result, we could see significant turnover in audit committee membership over the next few years. Future audit committee members may become more proactive and focused on their responsibilities with an underlying attitude of healthy skepticism.

Establishing an Effective Framework

In the wake of this demanding environment, an audit committee framework that facilitates the coordination of the activities and information needed to support the committee's understanding and monitoring of the company's financial reporting process must be established. Financial reporting risks facing the company should be the primary driver of the audit committee process. A well-defined framework will allow the audit committee to receive the right information, at the right time, from the right individual, and in the right context to provide effective oversight.

Taking Responsibility

One of the most significant changes brought on by the corporate accountability reforms is the audit committee's direct responsibility for the oversight of the external auditor. The shift from the external auditors being "ultimately accountable" to "directly responsible" to the audit committee is powerful, and a change that audit committees and external auditors are taking very seriously.

Audit committees now are meeting with the external auditor much more often and in many cases outside the formal audit committee meetings. They are also closely evaluating, and pre-approving, all services provided by the external auditor. Further, they are evaluating the external auditor's qualifications and independence, participating in fee discussions, and asking more questions about audit scope and complex accounting matters, including alternate treatments that may have been discussed with management. The bottom line: the external auditor works with management but works for the audit committee, and the audit committee expects to be treated as "the client."

Conclusion

In summary, audit committees today are dealing with a multitude of issues that will require their thoughtful, active participation to effectively integrate them into their culture and oversight approach. This dynamic, changing environment requires everyone to adapt to new developments as they emerge. It is causing the roles, responsibilities and accountabilities of boards of directors, including the audit committee, senior management, internal auditors, and external auditors, to be reshaped and redefined.

The audit committee's oversight role is a critical element of the financial reporting process. An audit committee member's role is more time-consuming and challenging than ever. Audit committee members must be independent of management, engaged, experienced, ethical, inquisitive and intuitive to provide effective oversight and help rebuild the public's trust in the capital markets.

Patrick Kinsella is an audit partner in KPMG LLP's Los Angeles office.

KPMG LLP is the audit, tax and advisory firm that has maintained a continuous commitment throughout its history to providing leadership, integrity and quality. KPMG LLP (www.us.kpmg.com) is the U.S. member firm of KPMG International.

KPMG International is the sponsor of KPMG's Audit Committee Institute (www.kpmg.com/aci). Celebrating its fifth anniversary, KPMG's Audit Committee Institute facilitates communication with audit committee members and senior officers to enhance awareness of effective audit committee processes and identify ways to implement them. Through its programs, ACI's leaders have met directly with thousands of directors and officers. The institute's initiatives include semiannual roundtables, conference and board presentations, as well as numerous publications and surveys.

All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity.