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The CEO and the audit committee.

An audit committee performs crucial oversight functions. But its effectiveness depends on the skills and priorities of its members and support from senior management.

As chairman and chief executive of Deloitte & Touche, I am the firm's senior client service partner. I spend a great deal of time with our clients in order to understand their needs and expectations, and to direct the resources of our firm to meet and exceed them. Participating in client service and ensuring that our services are top quality are among the most rewarding aspects of my job.

In this role, I work with a number of the most sophisticated, talented, and effective audit committees in the U.S. I believe these committees add considerable value to the quality and credibility of our financial reporting process, which is, in my opinion, justifiably recognized to be the finest in the world. Their oversight of auditing functions and of a company's internal control system helps to protect shareholder interests by keeping business on the straight and narrow.

HERE TO STAY

Audit committees have been a part of our system for over 50 years. Soon after its own formation to protect investors, the Securities and Exchange Commission urged public corporations "to establish a committee of non-officer directors to focus on the quality of financial reporting and, thereby, protect shareholders' interests." Since then, the concept has been explored, refined, expanded, codified, and mandated in various forms by bodies such as Congress, the New York Stock Exchange, and the AICPA. The audit committee movement received a boost from the disclosures of improper corporate conduct that precipitated the passage of the Foreign Corrupt Practices Act in 1977, and again from the incidence of fraudulent financial reporting that led to the formation of the Commission on Fraudulent Financial Reporting (the "Treadway Commission") in 1985. Although the Treadway Commission recommended that the SEC mandate audit committees for all public companies, such a comprehensive measure has never been enacted. Nevertheless, in almost all public companies, audit committees have become an essential part of the governance structure.

GUIDANCE FOR AUDIT COMMITTEES

Early writings on audit committees focused on their origin; development; membership composition; and "mechanics," such as size, frequency of meetings, and agenda setting.

The most comprehensive and instructive guidance on audit committee operations can be found in the October 1987 Report of the Treadway Commission. In it, the commission concludes that the audit committee is a necessary component of the financial reporting process and serves to deter fraudulent financial reporting.

The Treadway report includes specific "good practice guidelines" for audit committees. Many audit committees periodically review their own activities by comparing them to these guidelines, often with the assistance of their external and internal auditors. Such periodic "check-ups" are in and of themselves a good practice for diligent audit committees.

Only one of the Treadway Commission's recommendations for audit committees has not been widely adopted: the suggestion that the annual report to shareholders include a report from the chairman of the audit committee on its function and activities. Only a few such reports are provided today. The principal reason given for non-acceptance of the recommendation is the belief that such a report likely will become legalistic boilerplate and, therefore, will not be informative. Also, many companies fear that the report may confuse the responsibilities of the audit committee with those of senior management as expressed in management's report which usually accompanies the financial statements in the annual report. Although I strongly support the Treadway Commission's recommendations in general, I don't think a separate report from the audit committee to the shareholders is a necessary part of the financial reporting process.

WHAT MAKES AN AUDIT COMMITTEE EFFECTIVE?

In my experience, the mechanics of the audit committee (i.e., its size, how often it meets, etc.) are far less important to its effectiveness than the composition of the committee and the support it receives from and gives to management. There is no substitute for active committee members with an appropriate (but not excessive) degree of inquisitiveness and skepticism. An audit committee member need not be an expert in financial reporting, although such expertise in one or two of the members is useful. More to the point is the members' knowledge of the business of the company and the industry in which it operates, and a constructive, inquiring approach to challenging the financial reporting practices of the company. In a nutshell, members should demonstrate the willingness and the ability to ask the right, tough questions of financial management, external and internal auditors, and legal counsel.

SUPPORT FOR THE AUDITORS

Another function of the audit committee is to provide private access to the board of directors for the external and internal auditors if critical matters cannot be properly resolved through normal channels. Usually, this access is rarely needed or used, because management is committed to the integrity and effectiveness of the company's financial reporting, control, and audit functions. Like homeowners insurance, however, the value of the function is not measured by the frequency of its use but rather by its reassuring presence.

OVERSIGHT RESPONSIBILITIES

Virtually all audit committees perform a few basic functions which generally can be described as oversight of the financial reporting process, of a company's internal control system, and of external and internal audit functions. Other activities of audit committees are as varied as the companies themselves.

Some which I have found to be valuable include:

* Oversight of a company's monitoring of compliance with its code of business conduct.

* Oversight of special investigations of matters that could affect a company's financial statements, such as illegal acts by employees, litigation against the company, and regulatory inquiries.

* Review of potentially sensitive accounting and disclosure issues such as: the timing and method of adoption of FAS 106 on post-retirement benefits; a company's accounting for environmental liabilities, a complex and uncertain area; a company's accounting for significant and often highly judgmental items, including restructuring reserves, profit recognition on long-term contracts, and the valuation of intangibles in business combinations.

Our professional standards require independent auditors to communicate each year certain information obtained during the audit process that is particularly relevant to the audit committee, including "close calls" in judgmental areas, potential adjustments to financial statements, weaknesses in internal controls, and disagreements with management. Although it is not unusual for no such items to crop up in a well-run company's audit, they do provide a useful framework for discussions of auditing and financial reporting matters, even when the bottom line reads, "Everything's fine."

THE CEO'S ROLE

The degree of CEO interaction with the audit committee varies. Some CEOs attend each meeting of the committee; others attend only if there are unusually sensitive or controversial issues on the agenda. The degree of CEO involvement "behind the scenes" also ranges from regular, direct interaction with the audit committee chairman to an "I'm available whenever you need me" relationship. Although I favor more direct involvement and interaction by the CEO, I've seen it work well other ways depending on the skills and priorities of the individuals and on the specific situation of the company.

A LOOK AHEAD

The current focus on corporate governance is unprecedented. There are increasing demands for management and boards of directors to respond to the needs of shareholders and other constituents. In this environment, an active, effective audit committee is vital to the credibility of the financial reporting process.

One caveat: I hope the current wave of concern, unlike responses to past "crises," will not cause some to urge audit committees to cross the line and assume managerial responsibilities. This must not be permitted to occur; the real effectiveness of an audit committee depends upon its proper role in the financial reporting process--an active oversight role--one that will be a high-value asset to any corporation.

EXHIBIT I MATTERS TO BE COMMUNICATED TO THE AUDIT COMMITTEE

Professional standards require that the auditor communicate to the audit committee information about the following items:

* Responsibility under generally accepted auditing standards.

* Significant accounting policies.

* Management judgments and accounting estimates.

* Significant audit adjustments, whether or not recorded.

* Other information in documents containing audited financial statements.

* Disagreements with management, whether or not satisfactorily resolved.

* Management consultation with other accountants.

* Major issues discussed with management prior to retention.

* Difficulties encountered in performing the audit.

EXHIBIT II RECOMMENDATIONS AND GOOD PRACTICE GUIDELINES FOR THE AUDIT COMMITTEE

The Report of the Treadway Commission contains specific recommendations for audit committees. Some examples are:

* Maintain a written charter specifying the duties and responsibilities of the audit committee.

* Strive to learn more about the company operations.

* Assist management in monitoring compliance with the code of corporate conduct.

* Examine management's plans for engaging, and reviewing the independence of, external auditors.

* Review the internal and external audit plans, including electronic data processing systems.

* Oversee the annual and quarterly financial reporting process.

* Meet regularly with company counsel.

* Perform a review of officers' expenses.

* Report regularly to the board of directors.

J. Michael Cook is chairman and chief executive of Deloitte & Touche, one of the nation's leading professional services firms. He is also chairman of the Oversight Committee of the Financial Accounting Foundation.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Governance
Author:Cook, J. Michael
Publication:Chief Executive (U.S.)
Date:Apr 1, 1993
Words:1516
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