Where Was The Audit Committee?
"Where was the auditor?" It's a question often asked by investors and others in the wake of allegations of fraudulent financial statements or a restatement of reported financial results. Now, as the role of the audit committee expands, investors are also wondering, "Where was the audit committee?" Is your audit committee prepared to answer?
In the last few years, the roles and responsibilities of the audit committee have been of interest to investors, legislators, regulators and the general public -- largely due to concern over several factors: a number of highly publicized cases of alleged fraudulent financial reporting that were costly to investors; errors requiring restatements of financial statements; the use of acceptable, but aggressive accounting principles; and "earnings management" practices to achieve desired financial results.
In response to this increased attention, a number of commissions and committees -- consisting of corporate executives, accounting and auditing practitioners, academics, regulators and others -- were formed to study the appropriate role of the audit committee. From these studies, new requirements and recommendations have emerged, resulting in audit committees taking a more proactive role in the oversight of financial reporting.
It's widely believed that the new practices would have gone a long way toward preventing the financial reporting abuses of the past. Thus, the following explores the practices and how they might improve the financial reporting process.
What Has Changed?
Recent significant activities of a number of groups assisting to enhance the effectiveness of audit committees include:
* The issuance in 1999 of the "Report of The Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees" (known as the Blue Ribbon Committee), sponsored by the New York Stock Exchange and the National Association of Securities Dealers (NASD). The report contains 10 recommendations for improving audit committees' performance. The report stresses that audit committee members need to be independent, possess financial literacy and recognize the significance of their responsibilities by devoting the appropriate amount of time to their tasks. The Blue Ribbon Committee also indicated the critical nature of the audit committee's relationships and communications with the independent auditors, the internal auditors and management.
* Recent pronouncements by the Auditing Standards Board have expanded the communications between independent auditors and the audit committee related to fraud, uncorrected audit adjustments and the quality of accounting principles used by management.
* Statement on Auditing Standards (SAS) 82, Consideration of Fraud in a Financial Statement Audit, requires that the independent auditor report directly to the audit committee any fraud involving senior management and fraud (whether caused by senior management or other employees) that causes a material misstatement of the financial statements. The audit committee should ask: Have there been any known instances of fraud, or possible fraud? What was done about them? How can they be prevented in the future?
* SAS 89, Audit Adjustments, requires that a summary of uncorrected misstatements be included in or attached to management's representation letter, and that the independent auditor inform the audit committee about uncorrected misstatements aggregated by the auditor during the current engagement and pertaining to the latest period presented that were determined by management to be immaterial -- both individually and in the aggregate -- to the financial statements taken as a whole. Audit committees should pay particular attention to the unrecorded adjustments and get satisfactory explanations from management as to why those adjustments were not recorded.
* The Blue Ribbon Committee recommended, and auditing standards now require, that the independent auditors discuss with the audit committee their judgments about the quality, not just the acceptability, of accounting principles in the company's financial reporting. The auditors should discuss the clarity of the company s financial disclosures, degree of aggressiveness or conservatism of the company's accounting principles and underlying estimates and other significant management decisions. The audit committee should focus on the qualitative aspects of financial reporting, such as evaluation of reserves and understanding the quality of the accounting principles used.
* In August 2000, The Panel on Audit Effectiveness (the Panel) issued its Report and Recommendations, which supported the audit committee's more proactive oversight role. The Panel recommended that audit committees increase the amount of time and attention they devote to discussions of internal control with management and the auditors, and that the audit committee establish specific expectations with management and the auditors about the qualitative information needs of the committee related to internal control, with particular emphasis on the control environment and the controls (or lack thereof) over financial reporting.
How Has This Changed What Audit Committees Do?
As a result of the implementation of these recommendations and requirements, audit committees have increased the depth of their understanding of the company's business. Such an understanding not only enables audit committee members to have a more thorough and candid dialogue with management about the company's risks, but also puts them in a better position to ask the right questions about reported financial results.
Audit committees also are focusing more on the company's internal controls; they expect periodic briefings regarding the company's controls from management, the internal auditors and the independent auditors. Audit committee members are not in a position to determine if the internal controls over the financial reporting process are functioning properly, so they must turn to others. Usually, that means asking questions of those directly responsible for internal controls -- meaning management. Management can provide background information on the internal controls, but audit committees also need independent views from the internal and independent auditors. The committee should review with the auditors and management their assessments of the company's controls and make sure that appropriate actions are being taken to correct any significant deficiencies. An environment in which management pays little attention to internal control, or fails to respond to control deficiencies noted by the auditors, may increase the risk of fraudulent financial reporting.
Armed with a better understanding of the business and financial reporting process, audit committees can ask more insightful questions about the financial statements and disclosures. Scrutiny of the financial statements might detect unusual activity, such as premature recognition of revenue as alleged in several recent enforcement actions by the Securities and Exchange Commission. For example, when analyzing the financial statements, the audit committee may question whether a spike in revenue at the end of a reporting period is in response to a sales promotion or represents an improper acceleration of revenue to meet revenue or earnings targets.
Why Are The Changes Significant?
A better understanding of the company's business and risks allows audit committee members to ask better, more focused questions when performing their oversight role. More candid discussions with the auditors (both internal and independent) help the audit committee understand management's view of the financial reporting process.
The audit committee can find out whether there is potential bias in estimates or judgments that may be indicative of "earnings management" or whether management is using aggressive or conservative accounting practices. The audit committee members also will better understand the nature of the audit differences and management's plan to correct them. This enables the timely resolution of audit differences and avoids having immaterial differences grow to a material amount over time.
The audit committee can encourage open lines of communication by holding regular meetings with management, the internal auditors and the independent auditors, including private sessions. Expectations should be set so that management and the auditors know that the audit committee wants to be informed of potential fraudulent activity and control-related matters when those events occur. Historically, those types of communications may have been made in conjunction with an annual meeting with the auditors. Now, many audit committees are holding at least quarterly meetings and/or conference calls to discuss matters as they arise.
Lastly, a better understanding of the financial reporting process helps the audit committee perform its oversight role. It's important to understand how management is involved in the financial reporting process and what control management has over the financial information that is reported. For example, the audit committee should understand management's ability to override or direct others to override the controls over information processed by the company's financial reporting system, such as through non-standard journal entries or "top-side" adjustments to the financial statements that are not reflected in the general ledger.
An audit committee that has taken a proactive role to understand the company, its internal controls and its financial reporting processes will be better prepared to exercise its important oversight responsibility over the financial reporting process. This can minimize the possibility of ever having to answer the question, "Where was the audit committee?"
Mark W. Pearson is national director of AABS (Assurance & Advisory Business Services) standards in Ernst & Young LLP's Cleveland office. He heads the groups responsible for assuring that the firm's assurance-related guidance complies with professional standards, as well as the firm's global internal quality control function.
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|Author:||Pearson, Mark W.|
|Date:||Nov 1, 2001|
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