Audit Committees

Audit committees are a key institution in the context of corporate governance because they help boards of directors fulfill their financial and fiduciary responsibilities to shareholders. Through their audit committees, boards of directors establish a direct line of communication between themselves and the internal and external auditors as well as the chief financial officer. Such an organizational structure and reporting responsibility in an environment of free and unrestricted access enables full boards of directors not only to gain assurance about the quality of financial reporting and audit processes, but also to approve of significant accounting policy decisions. Moreover, strong and effective audit committees, through their planning, review, and monitoring activities, can recognize problem areas and take corrective action before such problems impact the company's financial statements and investors. Thus, audit committees have an important role in helping boards of directors avoid litigation risk because such committees provide due diligence related to financial reporting.

REQUIREMENT FOR AUDIT COMMITTEES

Audit committees have long been seen as an important group in assuring greater corporate accountability in the United States. The value of such committees has been noted by the U.S. Congress, the U.S. Securities and Exchange Commission, the New York Stock Exchange, and the American Institute of Certified Public Accountants. Audit committees are required by the New York Stock Exchange, American Stock Exchange, and National Association of Securities Dealers (NASDAQ/NMS issuers).

Key recommendations and decisions in the evolution of audit committees in the United States include the following

1940

The Securities and Exchange Commission (SEC) recommended the establishment of audit committees (Accounting Series Release No. 19). Specifically, the SEC recommended that shareholders elect the auditors at annual meetings and a committee of nonofficer directors nominate the auditors. Also, the New York Stock Exchange Board of Governors issued a similar recommendation.

1967

The executive committee of the American Institute of Certified Public Accountants (AICPA) recommended that publicly held corporations establish audit committees to nominate the auditors and discuss the audit.

1972

The SEC issued Accounting Series Release No. 123, "Standing Audit Committees Composed of Outside Directors."

1973

The New York Stock Exchange (NYSE) issued a white paper, "Recommendations and Comments on Financial Reporting to Shareholders and Related Matters," strongly recommending that each listed company form an audit committee.

1974

The SEC amended Regulation 14A dealing with the proxy rules. Registrants are required to disclose in their proxy statements the existence of audit committees and the names of the committee members.

1977

A NYSE audit committee policy statement required each domestic corporation listed on the exchange to establish and maintain an audit committee of outside directors before July 1, 1978.

1987

The National Commission on Fraudulent Financial Reporting recommended that the SEC require that all public companies have audit committees.

1987

The National Association of Securities Dealers required each NASDAQ/NMS issuer to establish an audit committee.

1991

Congress passed the Federal Deposit Insurance Corporation Improvement Act. The law provided for the establishment of audit committees for insured depository institutions that have total assets of $150,000,000 or more.

1993

American Stock Exchange required its listed companies to establish audit committees.

1994

The American Law Institute issued Principles of Corporate Governance: Analysis and Recommendations. The Institute strongly supported and endorsed the concept of audit committees.

1999

The Independence Standards Board issued its first standard, "Independence Discussions with Audit Committees," which requires independent auditors to issue an annual independence confirmation to the audit committee of the company.

1999

The SEC approved changes to its rules to implement several of the recommendations by the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. Registrants are required to disclose information about audit committee composition and practices.

In addition to the presence of audit committees on U.S. stock exchanges, a number of stock exchanges in Canada, Europe, Africa, the Middle East, and the Asia/Pacific region have adopted audit committees. As worldwide financial markets expand and more companies are listed on major stock exchanges in different countries, the international investing public's demand for consistent and equal oversight protection through the use of audit committees will continue. In addition, international investors are concerned about the quality of corporate governance because of the impact of financial collapses and alleged frauds on securities markets.

In response, a number of stock exchanges have adopted audit committees to increase transparency and competence in the management of their listed member companies in order to deal effectively with attracting foreign equity investment.

ORGANIZATION AND STRUCTURE OF AUDIT COMMITTEES

Boards of directors form their audit committees by either passing a board resolution or amending corporate bylaws. Audit committees' responsibilities should be clearly defined and documented in their charter. Although the scope of the audit committees' responsibilities is predetermined by boards, the committees should be allowed to expand their charge with board approval and

investigate significant matters that impact financial reporting disclosures.

Boards of directors should carefully give consideration to the following points with respect to their appointments of directors to audit committees:

1. Number of directors: The number of independent directors appointed to audit committees depends on the nature of the business and industry dynamics, the size of the company, and the size of the board of directors. The general consensus seems to be that three to five members are adequate.
2. Composition: Because members of audit committees have varied backgrounds and occupations, they provide a mix of skills and experience. Although the members have different levels of expertise, it is strongly advisable to have at least one individual who has a financial accounting background.
3. Meetings: Audit committees meet from one to four times each year, with three or four meetings being the most common schedules.

NATURE OF AUDIT COMMITTEES RESPONSIBILITIES

Boards of directors define the role and responsibilities of their audit committees. This jurisdictional charge is usually disclosed in the audit committees' written charter, which includes the terms of reference, such as mission statement, membership (size and composition), term of service, frequency of meetings, scope of responsibilities, and reporting responsibilities. Audit committees are primarily responsible for the quality related to such matters as:

• External auditing process
• Internal auditing process
• Internal controls
• Conflicts of interest (code of corporate conduct, fraud presentation)
• Financial reporting process
• Regulatory and legal matters
• Other matters (interim reporting, information technology, officers' expense accounts)

Although boards of directors have defined the responsibilities of audit committees, boards may expand the scope of the audit committees' charter; however, boards should avoid diluting the committees' charge with information over-load. Recognizing that audit committees operate on a part-time basis and serve in an advisory capacity to boards, it is essential that boards place limitations on the scope of the committees' charge. Such a scope limitation enables boards to evaluate the committees' performance as well as protect the committees against legal claims for their inactions that are outside their charge. An illustration of the roles and responsibilities of audit committees is disclosed in the annual proxy statement of a company.

BLUE RIBBON COMMITTEE ON IMPROVING THE EFFECTIVENESS OF CORPORATE AUDIT COMMITTEES

On September 28, 1998, Arthur Levitt, chairman of the SEC, presented an address at the New York University Center for Law and Business entitled "The Numbers Game." He discussed matters related to the issues involving the quality of financial reporting (e.g., earnings management, reserves, audit adjustments, revenue recognition, creative acquisition accounting, in-process research and development, and restructuring charges). Because these issues impact a firm's quality of earnings and market capitalization (e.g., price-earnings ratios), Levitt requested a response from the entire financial community.

In response to Levitt's concerns, in October 1998, the New York Stock Exchange and the National Association of Securities Dealers created the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. In February 1999, the committee issued its report, which contains ten recommendations designed to (1) strengthen the independence of audit committees; (2) increase the effectiveness of audit committees; and (3) improve the relationship

between boards and their audit committees the activities of auditors and management. In December 1999, the SEC approved changes to its rules to implement several of the Blue Ribbon Committee's recommendations with respect to audit committee composition and practices.

In view of the aforementioned recommendations of the Blue Ribbon Committee, it is clearly evident that the scope for the responsibilities of audit committees will significantly increase. Therefore, it is essential that audit committees engage in an active continuous educational improvement program to help their boards discharge their fiduciary responsibilities to share holders.

The duties of the Audit Committee are (a) to recommend to the Board of Directors a firm of independent accountants to perform the examination of the annual financial statements of the Company; (b) to review with the independent accountants and with the Controller the pro posed scope of the annual audit, past audit experience, the Company's internal audit program, recently completed internal audits and other matters bearing upon the scope of the audit; (c) to review with the independent accountants and with the Controller significant matters revealed in the course of the audit of the annual financial statements of the Company; (d) to review on a regular basis whether the Company's Standards of Business Conduct and Corporate Policies relating thereto has been communicated by the Company to all key employees of the Company and its subsidiaries throughout the world with a direction that all such key employees certify that they have read, understand and are not aware of any violation of the Standards of Business Con duct; (e) to review with the Controller any suggestions and recommendations of the independent accountants concerning the internal control standards and accounting procedures of the Company; (f) to meet on a regular basis with a representative or representatives of the Internal Audit Department of the Company and to review the Internal Audit Department's Reports of Operations; and (g) to report its activities and actions to the Board at least once each fiscal year.