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Board of director acceptance of treadway responsibilities: how has top management accepted responsibility for identifying factors that may cause fraudulent misstatement of financial statements?

In October 1987, the Report of the National Commission on Fraudulent Financial Reporting (known as the Treadway commission report) made several important recommendations.

Among other things, it recommended that top management identify, understand and assess factors that may cause fraudulent misstatement of financial statements. It also recommended maintaining effective internal control and accounting and internal audit functions in companies and enforcement of a code of corporate conduct.

The commission recommended establishing an audit committee composed solely of independent directors. Such a committee should be "informed, vigilant and effective overseers of the financial reporting process and the company's internal controls." Specific activities recommended for the audit committee included reviewing the process of monitoring compliance with the code of conduct, helping to maintain the independence of the public accountants, overseeing the quarterly reporting process and having its chairman describe the committee's responsibilities and activities in the annual report.

Has the Treadway commission made a difference? And to what extent have boards of directors and board audit committees changed their operating methods? Evidence indicates most boards were either already following or have since implemented these recommendations. Audit committee chairpeople generally believe their committees are the informed, vigilant and effective overseers" described in the Treadway report.


These conclusions are ba ed on interviews with the chairpeople of 13 board of director audit committees (of 12 publicly held corporations and one subsidiary of a public company). Study participants, including Sears, Dynascam and FMC, ranged in size from those with 313 to 500,000 employees and those with assets of $46 million to nearly $87 billion. All were listed on a major stock exchange. See the sidebar on page 68 for the audit committee requirements major stock exchanges impose.)

With two exceptions-the initial question-structuring interview and one company selected because the audit committee chairperson reports to stockholders in the annual report-companies were selected randomly from a list of 32 Illinois corporations. Study participants were limited to Illinois corporations for two reasons:

* They would more likely respond favorably to an interview request from an in-state university.

* Travel would be minimized. Some geographical bias may be reflected in the findings, although the direction of such a bias would be difficult to ascertain.



Board members. Boards tend to be populated by competent and busy executives, most with other fulltime jobs. The average time allocated by the audit committee chairperson to board duty in the past year amounted to 143 hours. Average time spent preparing for meetings was slightly more than that spent in them. Exhibit 1, page 69, shows a breakdown of time spent by audit committee chairpeople on board activity.

The value of the chairperson's investment in the corporation ranged from $2,500 to $1,300,000, with an average of $290,000 (median of $115,000). Annual compensation for board duty varied from a low of $6,000 to a high of $52,500, with an average of $25,000. The computed hourly rate of compensation varied from a low of $42 to a high of $491, an average of $207. These data also are illustrated in exhibit 1.

On a scale of 1 for acquaintanceship to 10 for best friend, interviewees rated their relationships with the CEOs from a low of 5 to a high of 9, with an average of 6. New board members tend to be selected from recommendations by current board members, with the CEO making most of the recommendations. A search firm seldom is used. The full board usually approves the candidate before he or she is asked to serve. The corporation typically provides director and officer liability insurance coverage, in amounts from $2 million to $125 million. Some also provide indemnification agreements. One corporation carries no such insurance, believing the high premiums are not justified in view of the extensive coverage exclusions.

Board meetings. Board meetings tend to be formal. The typical atmosphere is viewed by the audit committee chairpeople as supportive. Most believe the board chairperson would view the atmosphere similarly, although three believe he or she would perceive it as more antagonistic.

Board meeting time is devoted mostly to reviewing reports, considering corporate strategy and policies, considering nonroutine opportunities and threats, assuring compliance with policies and evaluating management performance. Differences of opinion seem to be freely expressed, although decisions may be deferred until a consensus is established. Dissenting votes are few in number because they tend to be resolved before formal votes are taken. The interviewees generally respect dissenters. Most, but not all, believe dissenting members are likely to be renominated to the board.

Boards vary significantly on the frequency of nonagenda topics initiated by nonmanagement members. The frequency ranges from very seldom to as high as 25% of the items discussed at meetings.

Monitoring activity. Board attention to the ethical behavior of corporate employees varies considerably. About half of the boards actively monitor compliance with company standards; the other half expect to be informed only of significant deviations. The competence and integrity of key people in the accounting and the internal audit functions are perceived by audit committee chairpeople to be high. Exhibit 2, below, shows how the committee chairpeople evaluate key personnel. All but 1 of the corporations has an internal audit function, and it plans to establish one when its size justifies the cost.

Overall, information provided by the corporation to board members is seen by the interviewees as adequate, objective and timely. This is illustrated in exhibit 3, page 70. Audit committee chairpeople report that adequacy varies among the different types of information provided. Measurements of efficiency are considered to be least adequate. Annual financial statements and annual profit plans are perceived as most adequate. Exhibit 4, page 70, shows the perceived adequacy of information provided to board members.



Each audit committee functions as an integral part of the board. Members have the same overall responsibility as other board members, plus the audit committee responsibility. They are typically appointed by the board chairperson and approved by the full board. The audit committees for the 13 corporations included in this study had an aggregate of 51 members, 48 of whom appeared to be independent of management. Committee size, frequency of meetings and time devoted by the chairperson can be found in exhibit 5, page 71.

When asked if they view the audit committee as a choice assignment compared to other board committee assignments, five chairpeople responded affirmatively, six preferred other assignments and two were indifferent. Almost all believe the audit committee is more time consuming than other committees. Eight believe audit committee members probably have greater liability exposure than members of other committees, but five do not. Some chairpeople report they spend more time reading and analyzing financial reports than they would if they were not audit committee members. The audit committee tends to maintain a continuing relationship with both internal and outside auditors. No chairperson expressed concern about the extent of nonaudit services performed by the CPA firm, although some place annual dollar limits for nonaudit services beyond which specific approval is required. All committees evaluate the firm's performance. Evaluation methods used range from discussion with management to a formal evaluation procedure.

What would cause a company to consider changing auditors? Answers included lack of competence (but not disagreement with management), poor performance, incompetent personnel, problems involving the integrity of the CPA firm, excessive cost, a dissatisfied CEO or an extremely dissatisfied chief financial officer, lack of attention, no new ideas, loss of confidence in the firm and an inability to provide needed services.

The CPA firm reviews quarterly reports before they are issued in seven cases and reviews only the second quarter in one case. Quarterly reports are not reviewed by the firm for 4 companies. One chairperson does not know whether quarterly reports are reviewed. All committees review the extent of the planned audit with the outside auditor at a regularly scheduled meeting. Within the last three years, six audit committees considered, with the outside auditor, increasing audit procedures, while only one considered decreasing the extent of planned audit procedures. Audit committees are aware of the audit fee paid, but, with only one exception, fees are negotiated by management, not the committee.

All committees had discussed the effectiveness of internal controls in some depth with the outside auditor within the past three years. And some of the interviewees believed they had been influential in strengthening the internal audit function. However, none had participated significantly with the CPA firm in assessing the possibility that financial statements might have been materially and fraudulently misstated.

What changes would chairpeople like to make to achieve more effective audit committee oversight? One or two might strengthen internal auditing, and at least one would have the CPA firm review quarterly reports before they are released. However, most are satisfied with their present oversight function. They generally give the impression that, when any change in oversight processes or procedures are needed, they are discussed and made without management opposition.

Ten of the chairpeople reported they believe the corporate priority of issuing objective financial statements is significantly higher than that of achieving specific profit objectives. None believes earnings are deliberately misstated, but three either have no opinion about the relative priority or seem less than positive that objectivity is more highly valued than achieving a given profit level. In evaluating the performance of their committees as "informed, vigilant and effective overseers of the financial reporting processes and the company's internal controls," committee chairpeople assigned grades on a 10-point scale, from a low of 5 to a high of 10, with an average of 8.


Only the company selected for inclusion in the study for that reason included a letter from the audit committee chairperson in the annual report. The company believes it is a useful Treadway-recommended method of communicating information to stockholders. Other companies tend to regard such a letter as an unnecessary cosmetic appendage and think key information is better in management's letter.

One committee chairperson was not familiar with the Treadway commission report when the interview was arranged but had reviewed it carefully by the time of the interview. Only 1 corporation out of 14 had no audit committee. One company did not have an internal audit function. Three audit committee members out of 51 probably would not qualify as being independent of management according to NYSE standards. Two of these are members of the company's law firm, and 1 is a consultant. Oversight of the quarterly reporting process appeared to be minimal in three cases. Monitoring compliance with the corporate code of conduct may or may not be effective, depending on the quality of exception reporting to the audit committee.


As individuals, the audit committee chairpeople studied are impressive. They have a sizable stake in ensuring the success of their corporations in the form of stock ownership. Each exhibits a high level of understanding about the corporation he or she helps direct. They are also sensitive to the expectation corporations should maintain effective internal controls and objectively report financial information. Most of the chairpeople left the impression their corporations currently meet almost all reasonable Treadway commission expectations.

Most audit committees seem to have been influenced by Treadway. Ten chairpeople believe the commission's report has exerted a positive and desirable influence on audit committees, corporate reporting and internal controls. Some believe their corporations and audit committees were following all significant recommendations before the report was issued. Almost all support its major recommendations. One chairperson observed that the report gives the audit committee a license to perform some functions that would otherwise have been awkward to initiate.

Although a number of exceptions exist, compliance by boards of directors with the Treadway recommendations seems significant.

Concern about other environmental factors, such as legal liability, also may have influenced board agendas and operating practices. The boards'practice of allowing and listening to dissent and advice from outside members is healthier than the popular belief that CEOs dominate passive boards. Treadway exceptions tend to be related to the size of the corporation and the exchange on which its shares are listed. Large NYSE corporations comply with almost all recommendations. However, the audit committee chairpeople of larger corporations in the sample tend to believe they were generally in compliance before the report was issued. Smaller corporations have had to take positive actions and incur some added costs to attain the current level of compliance.

One caution is in order. The sample may be biased in favor of corporations that support the Treadway commission recommendations. Although the commission was not mentioned when the interview was requested, one reason for not responding to the request for interview could have been that commission recommendations had not been followed. One might assume corporations that comply with the Treadway recommendations would be more willing to discuss their policies and practices.


Significant compliance by most companies provides convincing evidence the Treadway recommendations are sound. To the extent practicable, companies should eliminate all major exceptions. Missing internal audit functions should be installed as soon as practicable. Programs for monitoring compliance with the corporate code of conduct should include positive steps by the audit committee to ensure that codes are monitored and exceptions handled properly. Audit committees should be appointed in all public corporations, and members should be independent of management. The quarterly reporting process should be monitored in view of the often dramatic reaction of stock prices to quarterly earnings reports.

The internal audit exception may be defendable for small corporations that hesitate to incur the fixed costs of the function and those in which external auditors perform procedures beyond those minimally required for a financial statement audit. Monitoring compliance with the code of conduct can surely be improved with little added cost. Monitoring the quarterly reporting process may involve only the added costs of a quarterly discussion with the audit committee about reporting decisions.

Audit committee membership exceptions seem difficult to justify. Board members who are not independent of management typically bring a high level of competence and company-specific knowledge to the board of directors. However, independence and the appearance of independence seem to have greater value than inside knowledge. Experience on the audit committee eventually will provide the necessary knowledge. The company lawyer, for example, is likely to be perceived as continuing his or her role as an advocate of management. Financial information users could arguably expect more objective financial reporting under the oversight of independent members. The impression gained from this study is that competent and independent people generally have been found to staff this important committee.

Including a letter from the audit committee chairperson in the annual report is a commission reeommendation that lacks board of director support. An overwhelming majority of the interviewees gave the impression this recommendation had been considered and found wanting. Indeed, the 1989 Accounting Trends & Techniques says only 13 out of the 600 annual reports analyzed include a letter from the audit committee chairperson. For some companies, a letter may be a logical extension of oral reports given at stockholders' meetings. Other companies may find equally effective ways to communicate the role and activities of the audit committee.

A last suggestion relates to the Treadway recommendation that top management "must identify, understand and assess the factors that may cause the company's financial statements to be fraudulently misstated." This study provides no evidence of consideration of possible fraudulent misstatements at the audit committee level. Fraud is such a repugnant idea that failure to explicitly consider it is not surprising. While its occurrence is rare, its impact can be disastrous. Explicit consideration of such misstatement might involve emotional cost, but almost no incremental dollar cost. Audit committees should reflect, perhaps annually, on incentives that may encourage, and on opportunities that may allow, fraudulent misstatements. Internal and external auditors can contribute to this consideration; indeed, they should go through similar thought processes. Policies may need to be changed or controls added, but adequate prevention may well eliminate the need for a cure. n
COPYRIGHT 1991 American Institute of CPA's
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Copyright 1991, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Rull, Ivan
Publication:Journal of Accountancy
Date:Feb 1, 1991
Previous Article:Understanding obligations of the FSLIC.
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