Benchmarking the audit committee.
Given the increased demand for greater corporate accountability, CPAs should consider three recent reports that identify bench marks for judging audit committee effectiveness.
* A U.S. General Accounting Office (GAO) survey of 40 of the largest U.S. banks' audit committee chairpersons. The survey was intended to support the need for legislation to reform the regulatory oversight of insured financial institutions.
* My study of audit committee functions that were specifically disclosed in the proxy statements or annual reports of the 251 largest publicly held U.S. corporations. The sample included all companies in all industries ranked both in the top 300 in revenue and at the same time in the top 400 in assets.
* A body of "best practice" recommendations for audit committees approved by the American Law Institute (ALI), a professional organization of practicing attorneys, judges and law school deans and professors. Since 1980, ALI has engaged in a comprehensive, far-reaching project to define the principles of corporate governance.
AUDIT COMMITTEE INDEPENDENCE
Independence from senior management is widely recognized as an important characteristic of effective audit committees. In the GAO survey, bank audit committee chairpersons ranked independence as the most important factor affecting the effectiveness of their committees' oversight. At the same time, however, 7.3% of the largest corporations publicly disclosed their audit committee chairperson had other business relationships with them that potentially impaired their independence. It appears few, if any, outside directors were chosen for their independence.
Korn Ferry International's annual survey of directors found the most sought-after personal characteristic of a director from a board chairperson's or chief executive officer's point of view was a supportive personality. Outside directors who are "idealistic, assertive, or eager to play the devil's advocate" were of less interest. The survey also found chairpersons' recommendations were the most fruitful means of identifying potential outside directors despite the existence on many boards of a nominating committee.
One likely reason for the lack of attention to independence is the flexibility of New York Stock Exchange rules for large publicly held corporations' audit committee appointments. Even persons with obvious conflicts of interest, including a corporation's consultants, significant vendors, major lenders and investment bankers as well as partners of the law firm representing it, can serve on or even chair its audit committee.
STATUTORY GUIDANCE ON INDEPENDENCE
FDICIA mandates that all insured depository institutions with assets of more than $500 million have an independent a committee as of this year, which affects an estimated 1,000 banks and savings associations. FDIC guidelines direct such institutions' boards to select only outside directors who are independent of management. Boards must consider relationships such as those of officers, employees (or their relatives) as well as investors, creditors or trustees.
The ALI report recommends outside directors be "free of any significant relationship" with the senior executives of the corporation. Significant relationships include those of legal representatives, investment bankers, family members, vendors and employees within the past two years. The ALI report also recommends state law require a majority of each large publicly held corporation's audit committee members meet this same criterion. As a matter of good corporate practice, ALI also recommends that all other public companies' boards have audit committees that include at least three independent members.
AUDIT COMMITTEE EXPERTISE
The GAO survey expressed concern bank audit committee members' expertise might not always match their oversight responsibilities; 35% of the audit committees reported no committee members had auditing or accounting expertise. In 32.5% of the institutions, there was no one on the audit committee with any legal expertise, even when the committee never met independently with the bank's general counsel.
Consequently, 95% of the institutions in the GAO survey reported placing great or very great reliance on the work and expertise of their external auditors in determining their oversight activities' effectiveness. The chairpersons of 82.5% of the committees also reported expecting the regular annual financial statement audit to identify all significant internal control weaknesses. In 55% of the cases, the chairpersons said they expected to a great or very great extent the annual audit also would identify any noncompliance with banking laws and regulations.
These expectations on the part of an overwhelming majority of large bank audit committee chairpersons appear to significantly exceed the audit engagement objectives in professional auditing literature and in generally accepted auditing standards. Audit committee chairpersons of an even larger percentage of small or medium-sized banks may have similar expectations. Thus, it is prudent for all CPA firms with bank and savings institution clients to emphasize these matters when discussing audit plans with the audit committee to dispel any unreasonable expectations.
As a legislative response to concerns about audit committee expertise, FDICIA requires the audit committees of very large banks and savings institutions to include at least two members with banking or financial management expertise. Guidelines for such institutions' boards include significant executive, professional, educational or regulatory experience in financial, auditing, accounting or banking matters.
FDICIA also requires very large institutions' audit committees to have access to their own outside counsel. The ALI report said independent directors (those with no significant relationship with the corporation's senior executives) should have the right to retain outside experts. This would allow audit and other oversight committee members to employ at the corporation's expense their own legal counsel, accountants or other experts to advise them.
BANK AUDIT COMMITTEE FUNCTIONS
In the GAO report, 70% of the audit committees considered monitoring adherence to established codes of conduct as one of their primary responsibilities. In contrast, the audit committees of only 4.5% of the banks included in my study specifically reported performing a similar oversight function in their proxy statements or annual reports.
This seeming disparity might result from several factors. Most likely, audit committee chairpersons are more willing to provide extensive, specific data about their activities in a confidential and anonymous survey than in a public disclosure. Many corporations undoubtedly believe their general oversight language covers the specific functions reported on separately by other corporations. For example, to some corporations the annual process of selecting an auditing firm may inherently include several other specific functions, including evaluating the firm's independence and reviewing the results of the previous year's audit.
Since the annual report disclosures are made according to voluntary private-sector initiatives, little formal guidance exists on what, and how, specific matters should be disclosed. Many corporations express their audit committee responsibility disclosures in general rather than specific terms. In my study, the phrase "determine whether their responsibilities are discharged properly" was used by a significant number of corporations. Nonspecific language such as "generally oversee financial reporting" was not tabulated.
The GAO survey found 95% of the audit committee chairpersons agreed their committees were responsible for
* Reviewing the adequacy of the internal control structure.
* Supervising the internal audit function.
* Assessing the adequacy of the external auditor's performance. Reflecting the regulatory environment of banks and savings institutions, 80% of the chairpersons reported their audit committees also were responsible for assessing compliance with banking laws and regulations.
Paradoxically, public reporting of specific bank audit committee oversight functions has lagged behind that of other industries. Except for internal audit oversight, the typical bank audit committee publicly reported performing fewer specific functions than audit committees in other industries. The emphasis on internal auditing may be due to bank audit committees' regulatory guidance. The lower number of functions reported by banks is remarkable given they reported a median of five audit committee meetings per year (the median in other industries was only three). The percentage of bank audit committees that reported performing selected specific functions is shown in the exhibit on page 61. As noted earlier, only specifically stated functions reported as being performed by the committee were tabulated.
AUDIT COMMITTEE FUNCTIONS IN OTHER INDUSTRIES
In the 229 largest publicly held corporations other than banks, the specific functions reported as being assigned to the audit committee by the full board varied widely. Audit committee functions set forth in the Corporate Director's Guidebook and the Report on Overview Committees (both published by the American Bar Association) were performed by a larger percentage of the largest corporations than other functions, even those included in a 1978 Securities and Exchange Commission proposal (not adopted) for disclosure of the nine customary audit committee functions.
In 39.4% of the largest corporations, the audit committee chairperson also served as the board chairperson or chief executive officer of another corporation. Some have questioned whether an individual who is being compensated (in many cases highly) to manage the affairs of one corporation can devote the time and energy necessary to perform the increasingly demanding functions of chairing another corporation's audit committee. The percentage of the largest corporations reporting publicly that their audit committees performed selected specific functions is shown in the exhibit.
BANK AUDIT COMMITTEE REQUIREMENTS UNDER FDICIA
Of the FDICIA provisions effective in 1993, the oversight responsibilities for audit committee members of institutions with over $500 million in assets are organized in five categories:
1. Relationships with external auditors
* Discuss the selection or termination of the external audit firm and any significant disagreements with it.
* Review the scope of external audit services, significant accounting policies and audit conclusions regarding significant accounting estimates.
2. Financial reporting
* Review financial statements and other financial reports before filing them with regulators.
3. Internal controls over financial reporting
* Review required management assertion and external auditor attestation reports before filing them with regulators.
* Review the adequacy of the internal control structure as well as management's resolution of identified weaknesses.
4. Compliance with designated laws and regulations
* Review required management assertion and external auditor attestation reports before filing them with regulators.
5. Relationships with internal auditors
* Oversee the internal audit function. These rules are likely to require significantly more time and expertise of affected institutions' audit committee members. They also are likely to result in substantially broadened legal liability for both directors and external auditors.
Extensive legal guidance from ALI, consisting of recommended best corporate practices for audit committee functions and powers, appears verbatim in the sidebar at left. These recommendations are intended for adoption by all public corporations regardless of size. In general, an audit committee is expected to review a corporation's processes for generating financial data, its internal controls and the independence of the corporation's external auditors and to facilitate a dialogue with the corporation's external and internal auditors.
Explanatory comments are provided by ALI to give further insight into the rationale underlying each recommended function and power. The internal audit functions are designed to parallel some of the external audit functions. For example, the audit committee review of the appointment or replacement of the senior internal auditing executive is intended to provide the same measure of independence from excessive influence by management as the audit committee recommendation of an external audit firm provides to the external auditor.
THE VALUE OF AUDIT COMMITTEES
In the present environment emphasizing world-class competition, it is interesting to note other countries also believe in the value of audit committees. In Canada, statutory requirements for such committees have existed for some time. In the United Kingdom, the Cadbury committee report mandated specific audit committee functions that are a condition of continued listing on the London Stock Exchange.
The statutory requirement for establishing a more independent audit committee in a substantial number of banks and savings institutions and mandating the performance of an extensive list of functions may be the precursor of even broader application to U.S. publicly held corporations. Thoughtful consideration by both public corporations and their auditors of audit committee independence, appropriate expertise and effective performance of appropriate duties and responsibilities is urgently required.
* IN THE FACE OF HEIGHTENED public expectations, Treadway commission recommendations and changes mandated by the FDIC Improvement Act, board of directors audit committees increasingly are being asked to accept responsibility in the search for greater corporate accountability.
* AUDIT COMMITTEES CAN USE three recent reports, a General Accounting Office (GAO) survey of bank audit committee chairpersons, a study of audit committee functions disclosed in proxy statements or annual reports and American Law Institute (ALI) recommendations to establish bench marks for their own performance.
* IN THE GAO SURVEY, BANK audit committee chairpersons ranked independence as the most important factor affecting the effectiveness of audit committee oversight. Even so, few outside directors appeared to be chosen for their independence.
* ALI RECOMMENDED AUDIT committee members be "free of any significant relationship" with senior executives. It said state laws should require all large publicly held corporations' audit committees to be composed of a majority of members meeting this criterion.
* THE SPECIFIC FUNCTIONS of audit committees reported in proxy material varied widely. On many boards, the audit committee chairperson also served as the chair or chief executive officer of another company, raising questions about the time and energy he or she could devote to audit committee responsibilities.
* IN CANADA, STATUTORY requirements for audit committees have existed for some time. In the United Kingdom, a recent report recommended specific audit committee functions be required as a condition of continued listing on the London Stock Exchange. FDICIA may be a precursor of a similar move in the United States.
AMERICAN LAW INSTITUTE RECOMMENDATIONS FOR BEST PRACTICE AUDIT COMMITTEE FUNCTIONS AND POWERS
* Recommend the firm to be employed as the corporation's
external auditor and review the proposed discharge of such
* Review the external auditor's compensation, the proposed
terms of its engagement and its independence.
* Review the appointment and replacement of the senior
internal auditing executive, if any.
* Serve as the channel of communication between the ex
ternal auditor and the board and between the senior internal
auditing executive, if any, and the board.
* Review the results of each external audit of the corporation,
the report of the audit, any related management letter,
management's responses to recommendations made by
the external audit in connection with the audit, reports of
the internal auditing department that are material to the
corporation as a whole and management's responses to
* Review the corporation's annual financial statements;
any certification, report, opinion or review rendered by the
external auditor in connection with those financial statements;
and any significant disputes between management
and the external auditor that arose in connection with the
preparation of those financial statements.
* Consider, in consultation with the external auditor and
the senior internal auditing executive, if any, the adequacy
of the corporation's internal controls.
* Consider major changes and other major questions of
choice respecting the appropriate auditing and accounting
principles and practices to be used in the preparation of the
corporation's financial statements when presented by the
external auditor, a principal senior executive, or otherwise.
CURTIS C. VERSCHOOR, CPA, EdD, is professor of accountancy at DePaul University, Chicago. He also maintains a practice in Barrington, Illinois, and is a member of the American Institute of CPAs, the Institute of Internal Auditors and the Institute of Management Accountants.
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|Author:||Verschoor, Curtis C.|
|Publication:||Journal of Accountancy|
|Date:||Sep 1, 1993|
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