Summary of Audit Committee Requirements,
Expectations and Best Practices
Agenda
§ Heightened Expectations of the Audit Committee
§ Restatements of Financial Statements
§ Overview of Audit Committee Requirements
§ Roles:
ØAudit Committee Members
ØManagement
ØExternal and Internal Auditors
§ What’s New for Audit Committees
§ Recent Events Affecting Financial Reporting
1
Heightened Expectations of the
Audit Committee
2
§
Well-publicized financial “surprises” have shocked many
§
Market value losses have been dramatic
§
Financial information has become increasingly complex
§
Considerable pressure from the financial community to
meet or exceed estimates has created emphasis on short
term results
§
Regulatory scrutiny has redefined “materiality” and
caused changes in accounting practices
Heightened Expectations of the
Audit Committee (Continued)
Questions Audit Committees are asking in response to the heightened expectations:
What risks could
significantly impact
the company?
How is management
addressing those
business risks?
How are we assured
that risks are
managed
appropriately?
• Do we have a process to assess the quality, not just the acceptability of accounting
policies, financial reporting processes and internal controls?
• Have we obtained an understanding of the processes used by management and
external auditors to identify and monitor risk?
• How are we assessing the effectiveness of the internal and external auditors?
• Have we evaluated the independence of the external auditors?
• Have we evaluated the quality of the finance, accounting and internal audit
organizations?
• How do we, as an audit committee, assess our own effectiveness?
3
Restatements of Financial Statements
250
200
57
150
100
9
50
0
33
48
51
32
61
50
58
59
150
1
156
91
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Source FEI Research Foundation study on the quantitative measures of the quality of financial reporting
4
IPR&D
All others
Financial Restatements –
Vulnerable Areas
An analysis of the financial restatements over the
past 14 years (1987 – 2000) reveals that revenue
and cost recognition merit special oversight
attention
254
360
67
94
305
5
Source FEI Research Foundation study on the quantitative measures of the quality of financial
reporting
Revenue
Cost
Loan Loss
IP R&D
Others
Overview of Audit Committee
Requirements
The Blue Ribbon Committee recommendations
adopted by the securities exchanges and the SEC
created the following requirements for Audit
Committees:
§ Audit committee membership and qualifications
§ Audit committee charter
§ Discussion about the quality of a company’s
accounting principles
§ Quarterly financial information
§ Audit committee report
6
Audit Committee Membership
and Qualifications
Audit Committee Size
§
Minimum of three members. All must be “independent”
directors
Director Independence
7
§
Three-year ban on employee of company, parent,
subsidiary or affiliate, or immediate family members of
executive officer
§
Ban on significant business relationship for three years
§
Ban on cross-compensation link
§
Override available for one non-independent director under
limited circumstances
Audit Committee Membership
and Qualifications
Financial Literacy
§ Financial literacy as determined by business
judgment of board of directors
§ Ability to read and understand fundamental
financial statements, including balance sheet,
statement of income and statement of cash flows
Financial Expertise
§ At least one member should have experience or
background in accounting or financial management
resulting in financial sophistication
8
Audit Committee Charter
Charter requirements:
§ Board must adopt charter
§ Charter to be reviewed annually by audit committee
§ Charter must be included as appendix to annual
proxy statement at least once every three years
9
Audit Committee Charter (Continued)
A formal, written charter that complies with
exchange listing requirements specifying:
§ Scope of responsibilities
§ Independent auditors are accountable to board and
audit committee
§ Board and audit committee have authority to select,
evaluate, and replace independent auditors
§ Audit committee to oversee independence of auditors
10
Audit Committee Charter (Continued)
Additional matters which may be documented in
the Charter:
§ Communications expectations
§ Investigative powers
§ Internal audit oversight
§ Oversight of litigation, taxation matters, related
party transactions and other legal, ethics and
compliance areas
§ Reporting responsibilities
11
Discussion About Quality of
Accounting Principles
Best practices for discussions:
§ Discussion should be three
way: audit committee,
management and auditors
§ Discussion should be open
and frank with the
objective of audit
committee members
gaining an understanding
of the quality, not just
acceptability, of
accounting principles
applied in financial
reporting
12
Quarterly Financial Information
§ Timely review of quarterly financial information
(prior to filing Form 10-Q) now required by
SEC
§ Results of auditors’ review to be communicated
to audit committee or its chair
Ø Details
Ø Best
ØA
13
to fit company circumstances
performed before earnings release
review is more limited than an audit
Audit Committee Report
§
An audit committee report must be included in proxy
statements for annual meetings of shareholders. The report
must disclose:
Ø
The audit committee’s review and discussion of the financial
statements with management
Ø The audit committee’s discussion with the independent auditors
of those matters required by AICPA Statement on Auditing
Standards (“SAS”) 61, Communication with Audit Committees
Ø The audit committee’s receipt from the independent auditors of
written independence disclosures and the discussion with them of
the auditors’ independence
Ø The audit committee’s recommendation that the audited financial
statements be included in the company’s 10-K
14
Role of Audit Committee Members
§ Attend and participate actively in each
meeting
§ Raise questions appropriate to an oversight
role
§ Primary link to the board for the external
auditors
§ Meet regularly and privately with external
and internal auditors
§ Confer in executive session
§ Diligent and knowledgeable membership
15
Role of Management
§ Core participants
Ø CEO,
§
Participants when agenda topics warrant
Ø
§
CFO, general counsel, chief internal auditor
Chief accounting officer, chief tax officer, business unit
management, others
Typical duties
Ø
Draft agenda for review and approval of committee chair
Ø Draft minutes
Ø Discuss areas of special concern or risk (e.g. tax matters)
Ø Discuss matters of unique interest to the board (e.g. EBITDA
accounting)
Ø Present and discuss internal audit results
Ø Respond to committee requests and requirements
16
Role of External Auditors
§ Participate in all audit committee meetings
§ Periodically meet with the Audit Committee
without management present
§ Conduct and report results of a timely review
of quarterly reporting
§ SAS 61 communications
§ Written statement of independence
17
Role of Internal Auditors
§ Develop and implement annual audit plan
§ Issue periodic reports on results of audit activities
§ Annual assessment of the adequacy and
effectiveness of control processes
§ Keep Audit Committee informed of emerging
trends and successful practices in internal
auditing.
§ Investigate suspected fraudulent activities within
the organization
§ Consider scope of external auditors’ work for the
purpose of providing optimal audit coverage
18
What’s New for Audit Committees
19
§
Adopt Blue Ribbon Committee recommendations
§
Consider environmental factors affecting financial
reporting
§
Understand and address financial reporting issues
Ø
Liquidity and going concern
Ø
Changes in internal control
Ø
Unusual transactions
Ø
Related party transactions, including SPEs
Ø
Materiality
Ø
Disclosure adequacy
Ø
Specific financial statement risk
What’s New for Audit Committees
(Continued)
AICPA Call to Action for Audit Committees:
§ Management’s “tone at the top”
§ Risk areas
§ Challenge estimates and judgments
§ Changes in the business environment
§ Understand the accounting, financial reporting
and internal control systems
§ Critical accounting principles
20
What’s New for Audit Committees
(Continued)
AICPA Call to Action for Audit Committees
(Continued):
§ Unrecorded audit adjustments
§ Related parties and disclosures
§ Financial statement users
§ High quality reporting
§ Oversight in gray areas of accounting and reporting
21
Deloitte & Touche Audit Committee
Effectiveness Services
Self Assess
Consult
Provide tools to assist audit
committees in conducting a
self-assessment of current
practices and, when
appropriate, benchmark those
practices against other
relevant audit committee
responses.
Discuss results of
self- assessment
and assist in
development of a
plan to help audit
committees improve
effectiveness.
Implement
Assist the audit
committee in
implementing a plan
that helps them better
understand and
monitor key risks and
financial reporting
issues.
Through the self-assessment process, audit committees can determine which
areas need to be addressed, including:
• Financial Literacy Training • Risk Management
• Corporate Governance and
Compliance
22
• Evaluation of Financial
Reporting Processes
• Assessment of Internal
and External Audit
Recent Events Affecting Financial
Reporting
Pro Forma Disclosures in Press Releases
§
SEC Cautionary Advice and Investor Alert About Pro Forma
Information
Ø
Presentation can be misleading if it omits material information
Ø
Anti-fraud provisions of federal securities laws apply
Ø
Disclosure should include the basis of presentation and describe
limitations and deviations from GAAP
Ø
Encourages companies to follow FEI/NIRI guidelines
Critical Accounting Policies
§
23
SEC Cautionary Advice on Disclosure about Critical Accounting
Policies
Ø
Investors deserve and demand full transparency of accounting
policies and their effects
Ø
Encourages full, plain-English explanations in MD&A about: