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An audit committee for dynamic times.

The escalating debate on corporate governance is likely to focus even more attention on the pivotal role of audit committees.

Frequent media headlines herald cases of corporate impropriety, management fraud, and the business failures of financial institutions. The public, governmental agencies, and legislative bodies have expressed great concern about issues of corporate accountability. This concern has placed significant demands on corporate management for more disclosure and increased responsibility. Meeting these demands requires a cooperative effort within the entire corporate structure - from the board of directors, to senior management, to all those involved in the financial reporting process.

Audit committees serve as a focal point of this effort, and the responsibilities of audit committee members are increasingly more demanding. Frequent changes in accounting and regulatory requirements, technological advances in accounting and control systems, and enhanced public expectations regarding corporate governance have significantly increased the need for, and role of, audit committees.

A recent proposal by Representative Wyden, "The Financial Fraud Detection and Disclosure Act," is an example of the expansion of audit committee responsibilities due to public expectations regarding corporate governance. If enacted, the proposal would legislate involvement by the audit committee of a public company in the oversight of remedial actions taken in the event that the company committed an illegal act. Further, if an illegal act had a material effect on the financial statements, and the remedial actions were not timely and appropriate, the auditor would be required to "blow the whistle" to the Securities and Exchange Commission.

The escalating debate on corporate governance is also likely to focus even more attention on audit committees as having a pivotal role between the interests of management and shareholders. Audit committees provide oversight of how management is fulfilling its responsibility for full and fair disclosure of financial results. Concepts of what constitutes full and fair disclosure, both within and outside of the formal financial statements, are likely to expand. It is not surprising that more and more companies and regulatory bodies are perceiving the value of audit committees. For example, the 1991 banking reform bill requires each insured depository institution with total assets of $150 million or more to have an independent audit committee made up of outside directors. Relatively recent surveys have shown an increasing number of public companies with audit committees, and there is no reason to expect a change in this trend. Some governmental and not-for-profit entities are now using audit committees.

The role of today's audit committee is expanding (1) because of its value to the board of directors and management, and (2) to meet challenges of ever-changing business conditions. These challenges include: * Widening concern regarding corporate ethics. * The increasing complexity of transactions, accounting standards, and regulatory requirements. * A cry for fair disclosure of the quality of the company's earnings and financial condition, and the resulting responsibility of management and the board for full and fair disclosure of financial results. * Globalization of markets, which has opened new opportunities, increased competition, and created and explosion of the information required to make informed decisions. * Widespread use of information technology, including microcomputers and networks, satellite transmissions, and introduction of electronic data interchange, all of which have changed internal control methods.

Together, today's event and trends are increasing the focus on audit committees as a key element in ensuring effective internal control and reliable financial reporting.

Primary Responsibilities

In board terms, the primary responsibilities generally assigned to an audit committee are: * Assisting the board to fulfill its oversight responsibilities as they relate to the financial reporting process and the internal control structure. * Maintaining, by way of regularly scheduled meetings, direct lines of communication between the board, financial management, the independent accountant, and internal audit.

Audit committee members do not necessarily need to possess special financial reporting expertise to meet these responsibilities. The most important attributes for members are an inquiring attitude, objectivity, judgment, and a sound understanding of the company's business. Also, committee members should be committed to the work and responsibilities of the committee and be able to devote the necessary time to preparation and meetings.

Oversight of Financial Reporting. Management is responsible for the interim and annual financial statements. Audit committees have oversight responsibility.

An audit committee should focus on that quality of the company's earnings and financial condition and the adequacy of disclosure of information essential to a fair presentation of the company's financial affairs. The accounting policies used can significantly affect the quality of a company's reported earnings. Consequently, among other matters, audit committees will be directing attention to recent and prospective accounting standards, such as other post-retirement benefits, income taxes, and marketable securities.

Many audit committees also assume oversight responsibility with respect to other information in public reports, especially the SEC-required management's discussion and analysis (MD&A). The SEC staff view MD&A as vital information for the investor in assessing future prospects. The staff are concerned that there still seems to be an apparent reluctance to disclose known adverse trends resulting from changing economic conditions - for example, environmental obligations, significant litigation, planned restructuring actions, or liquidity restrains. The audit committee should satisfy itself that MD&A and the other information is consistent with the financial statements and adequately describes the company's business and financial affairs.

Oversight of Internal Control. Management has the responsibility to establish and maintain an internal control structure that provides reasonable assurance of safeguarding the company's assets and of reliable financial reporting. An effective internal control structure starts with the tone at the top and filters down through the entity to specific accounting and control procedures. The audit committee's oversight is an important influence in determining that tone.

Today's environment has sharpened the already strong focus on internal control that exists in many companies. There has been a number of proposals to require management to report publicly on its responsibility for maintaining internal control over the financial reporting process and on its assessment of the effectiveness of that system. And the 1991 banking reform bill requires managements and independent auditors of larger institutions to report on internal control over financial reporting and complying with laws and regulations related to safety and soundness. If required, the reporting should be based on reasonably objective criteria. The Committee of Sponsoring Organizations (COSO) of the Treadway Commission is continuing its work to establish reasonably objective criteria in its project, "Internal Control - Integrated Framework." A final report is expected this year.

The COSO project's primary objectives are to provide a common ground for mutual understanding of internal control and to provide criteria against which to assess internal control and identify areas for improvement. Interestingly, the COSO study indicates that when there are control failures, they often result from deficiencies in one or more of the following: - Lack of integrity, or ignoring ethical values, on the part of top management; - A weak or negative control environment; - Failure to link top-level objectives with objectives for operating and support units; - Poor communication within the organization; and - Inability to understand and react to changing conditions.

Committee Support

Audit committees rely on two key professional resources for additional support: internal audit and independent accountants.

Internal audit is a primary resource supporting the audit committee in fulfilling its oversight responsibility for the internal control structure, and many companies have recognized the benefits of having a highly competent, professional internal audit function. Management and the audit committee of each company charge internal audit with a responsibility for examination and evaluation of the internal control structure and give general direction as to the scope of the work and the activities to be audited.

As companies become more dependent on computerized information systems, the development, continual monitoring, and periodic assessment of controls over those systems become more important and, in many cases, critical to business success. To assist internal auditors and others, the Institute of Internal Auditors (IIA) Research Foundation recently released Systems Auditability and Control (SAC), a 12-volume report researched by Price Waterhouse which contains the latest information available on assessing the risks, management, control, audit, and integrity of automated systems.

The independent accountant is required to report significant known deficiencies in the internal control structure to the audit committee. The independent accountant also reports lesser deficiencies in internal control and suggestions for operational improvements to management.

Other Responsibilities

The role of an audit committee is varied and evolving, as it should be to meet the needs of individual companies operating in today's dynamic economics. The constant guiding principle is that the role and responsibilities of the audit committee be designed to suit the needs of the company's board.

In addition to the expanding requirements of their primary responsibilities, today's business climate encourages continuing expansion of audit committee responsibilities toward overall corporate governance. Some audit committees take steps to provide assurance that the company is in reasonable compliance with pertinent laws and regulations, is conducting its affairs ethically, and is maintaining effective controls against employee conflict of interests and fraud.

The following illustrates the diversity of additional duties currently being assumed by some audit committees: * Reviewing corporate policies relating to compliance with laws and regulations, ethics, conflict of interests, and the investigation of misconduct and fraud. * Conducting periodic reviewers of current/pending litigation or regulatory proceedings bearing on corporate governance in which the corporation is a party. * Coordinating annual reviews of compliance with corporate governance policies through internal audit or the company's independent accountants. * Performing or supervising special investigations. * Reviewing executive expenses. * Reviewing policies on sensitive payments. * Reviewing past or proposed transactions between the corporation and members of management. * Reviewing the corporation's benefits programs. * Assessing the performance of financial management.

The broader scope of the audit committee's responsibilities should not, however, strain its resources to the point that attention to the primary responsibilities is neglected.

Advisory Guides

These are interesting and demanding times for audit committees. As noted, the globalization of markets, the sophistication of technology, and the increasing complexity of transactions, accounting standards, and regulatory requirements will continue to present challenges to audit committees. To help audit committee members meet these challenges, Price Waterhouse has recently published two booklets related to audit committees: The Audit Committee and Forming an Audit Committee. The Audit Committee is intended for audit committee members and for management that works with them. It describes, in general terms, developments in auditing standards and practice affecting the primary responsibilities of audit committees. Forming an Audit Committee is intended for CEOs and others who are considering forming an audit committee or will have some responsibility involving a newly formed audit committee.

Ray Bromark is a Partner and Deputy Vice Chairman of Accounting and Auditing Services, and Ralph Hoffman s a Partner in the Auditing Services Department, of Price Waterhouse, a leading worldwide professional services organization of business advisers, accountants, and tax and management consultants.
COPYRIGHT 1992 Directors and Boards
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Chairman's Agenda: Governing for Shareholder Prosperity
Author:Bromark, Ray; Hoffman, Ralph
Publication:Directors & Boards
Date:Mar 22, 1992
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