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Business (Washington, DC: SEC, September 28, 1998).
Levitt, Arthur, “Letter to Audit Committees Chairmen of the Top 5000 Public Companies”
(Washington, DC: SEC, January 5, 2001).
Lovdal, Michael L., “Making the Audit Committee Work.” Harvard Business Review 55
(March“April 1977), pp. 108“114.
Luscombe, Nelson, “More Power to Audit Committees.” CA Magazine 122, No. 5 (May
1989), pp. 26“37.
McCauley, Daniel J., and John C. Burton, Audit Committees. C.P.S. No. 49 (Washington,
DC: The Bureau of National Affairs, Inc., 1986).
McCuaig, Bruce W. and Paul G. Makosz, “Is Everything Under Control? A New Approach
to Corporate Governance.” Financial Executive 6, No. 1 (January/February 1990), pp.
24“29.
Miller, Richard I., and Paul H. Pashkoff, “Regulations under the Sarbanes-Oxley Act.”
Journal of Accountancy 194, No. 4 (October 2002), pp. 33“36.
Morrissey, John, “Corporate Responsibility and the Audit Committee,” speech presented at
the General Audit Management Conference (Washington, DC: SEC, March 21, 2000).
Olson, John F., Ronald O. Mueller, Stephanie Tsacoumis, and Amy L. Goodman, “After
Enron: Issues for Boards and Audit Committees to Consider.” Insights 16, No. 4 (April
2002), pp. 2“8.
O™Malley, Shaun F., “Auditing, Directors, and Management: Promoting Accountability.” In-
ternal Auditing 5, No. 3 (Winter 1990), pp. 3“9.
Palmer, Russell E., “Audit Committees”Are They Effective? An Auditor™s View.” Journal
of Accountancy 144, No. 3 (September 1977), pp. 76“79.
Panel on Audit Effectiveness, Panel on Audit Effectiveness Report and Recommendations
(Stamford, CT: POB, 2000).
Pearson, Mark W., “Where Was the Audit Committee?” Financial Executive 17, No. 8 (No-
vember 2001), pp. 44“47.
Read, William J., and Kannass Raghunandan, “The State of Audit Committees.” Journal of
Accountancy 191, No. 5 (May 2001), pp. 57“60.
Rouse, Robert W., and Mark R. Borrelli, “Audit Committees in an Era of Increased
Scrutiny,” CPA Journal 70, No. 6 (June 2000), pp. 26“32.
Sarbanes-Oxley Act of 2002, H.R. Rep. No. 107-610, July 25, 2002. Title 1 of Public Law
No. 107-204, July 30, 2002.
Securities and Exchange Commission Release No. 34-47672, File No. SR-NYSE-2002-03,
Proposed Rule Changes Relating to Corporate Governance (Washington, DC, April 11,
2003).
Sources and Suggested Readings 41


Shandor, John, “Audit Committees Take a Broader Role in Corporate Policy.” Corporate
Controller 2 (November/December 1989), pp. 46“48.
Sweeney, Paul, “Audit Committees Bracing for Shakeys.” Financial Executive 18, No. 9,
(December 2002), pp. 16“18.
Terrill, Mark C., and Timothy J. Zanni, “CFOs and Audit Committees: Mutual Expecta-
tions.” CPA Journal 72, No. 2 (February 2002), p. 54.
Turley, James S., “The Future of Corporate Reporting: From the Top.” Financial Executive
70 (December 2002), p. 2.
Turner, Lynn E., “Audit Committees: A Roadway for Establishing Accountability.” In-
sights, the Corporate & Securities Law Advisor 15, No. 5 (May 2001), pp. 17“24.
Wechsler, Dana, “Giving the Watchdog Fangs.” Forbes 144 (November 13, 1989), pp. 130,
132“133.
Whitehead, John C., “A Healthy ˜Self-Cleaning™: What Can and Should Be Done Now to
Restore Confidence in the System.” Directors & Boards 26, No. 3 (Spring 2002), pp.
88“91.
Williams, Harold M., “Audit Committees”The Public Sector™s View.” Journal of Accoun-
tancy 144 No. 3 (September 1977), pp. 71“74.
Chapter 2
Audit Committees:
Basic Roles and
Responsibilities

The major purpose of this chapter is not only to examine the organizational and
functional characteristics of the audit committee but also to introduce the nature
and importance of the external and internal auditing processes. Conceptually, one
should understand the following:

• The basic considerations in forming the audit committee
• The basic audit committee functions
• The role of the audit committee with respect to the external and internal audit-
ing processes


ORGANIZATION OF THE AUDIT COMMITTEE
Nature of the Audit Committee
In view of the complexity of the modern corporation and the increased demands
for corporate accountability, the audit committee™s role has become an increas-
ingly important consideration in the conduct of corporate affairs.1 As defined by
the American Institute of Certified Public Accounts (AICPA), “An audit commit-
tee should be organized as a standing committee of the board composed mainly

1
With respect to critical issues, Korn/Ferry International found in its annual survey of 327 chief exec-
utive officers that:
According to our respondents, chief executive officers believe their attention should focus on
financial results, followed by maximizing shareholder value and executive leadership. Eighty-
five percent ranked financial results as most deserving of their time and 83 percent ranked
maximizing shareholder value as most important. Executive leadership was seen as the most
important issue by 81 percent of responding CEOs. (p. 12)
In another survey of 1,020 directors, Korn/Ferry International found that among the greatest chal-
lenges facing boards of directors are “board independence, shareholder value and effective strategic
planning” along with two dominant challenges, namely, “management succession and recruiting good
directors” (p. 5). As Richard M. Ferry, chairman of Korn/Ferry International, points out:
Two overwhelming trends are cited as the most important developments during the past 25
years in board policy and structure”the emerging independence of the audit, compensation


42
Organization of the Audit Committee 43


of nonofficer directors.”2 In Section 2 (a) (3) of the Sarbanes-Oxley Act of 2002,
the U.S. Congress reaffirmed the AICPA™s definition of the audit committee,
stating:

(3) AUDIT COMMITTEE”The term “audit committee” means”
(A) a committee (or equivalent body) established by and amongst the board of
directors of an issuer for the purpose of overseeing the accounting and fi-
nancial reporting processes of the issuer and audits of the financial state-
ments of the issuer; and
(B) if no such committee exists with respect to an issuer, the entire board of di-
rectors of the issuer.3

In contrast to the other standing committees of the board, such as the executive or
finance committees, the audit committee is unique because it consists of outside or
independent directors. Independent directors are individuals who are not directly
involved in managing the corporation. For example, the chief executive officer and
chief financial officer are considered management directors because not only are
they immediately involved in managing corporate affairs, they are also employees
of the corporation. Thus the independent audit committee is composed of individ-
uals who are nonmanagement directors.
The Corporate Organization Policy Committee of The Business Roundtable
concluded that the board of directors should be served by an audit committee be-
cause it would allow committee members to focus their attention on corporate
matters in greater depth than would be practical for the full board. Moreover, a
Conference Board study on audit committees found that “93 percent of the sur-
veyed companies have such a committee. The recent action of the New York Stock
Exchange requiring the 1,200 or so listed companies to establish by mid-1978
such a committee made up solely of directors independent of management rein-
forces this development.” 4 (See also Appendix D on the book™s website.)
In a subsequent survey of 692 companies (628 companies compared with
1978), the Conference Board found a significant increase in the audit committee™s
involvement in such activities as reviewing the internal audit function and the
independent status of the outside auditors, approving both audit and nonaudit



and nominating committees and the presence of fewer inside directors. Other major changes
are the rise in formal evaluations of CEO [chief executive officer] performance, the increased
strictness regarding directors with conflicting interests, the increasing popularity of corporate
governance committees, the increasing diversity of board composition and, somewhat surpris-
ingly, the trend toward paying directors in stock. (p. 9)
See Korn/Ferry International, Twentieth Annual Board of Directors Study, and Twenty-fifth Annual
Board of Directors Study (New York: Korn/Ferry International, 1993 and 1998).
2
American Institute of Certified Public Accountants, Audit Committees, Answers to Typical Questions
About Their Organization and Operations (New York: AICPA, 1978), p. 11.
3
The act is contained in Title 1 of Public Law No. 107-204, July 30, 2002.
4
The Business Roundtable, The Role and Composition of the Board of Directors of the Large Publicly
Owned Corporation (New York: The Business Roundtable, 1978), pp. 21“22.
44 Audit Committees: Basic Roles and Responsibilities


services and related fees, and preparing a written agenda in advance of the meet-
ings. They concluded that:

Audit committees are larger: median sizes are now 4 members for manufacturing and
nonfinancial services companies”up from 3 in 1978”and 4.5 for financial firms,
up from 4.
Their members include fewer directors with relationships that might interfere with
the exercise of independent judgment, especially former executives of the company
and directors affiliated with banks serving the company. Ninety percent of the com-
mittees have no members with such a potential conflict of interest.5

Notwithstanding the Conference Board survey results, the National Commission
on Fraudulent Financial Reporting (NCFFR) endorsed the principle that “the
board of directors of all public companies should be required by SEC rule to es-
tablish audit committees composed solely of independent directors.”6 The Com-
mission recommended that senior management set the tone for the corporation™s
control environment, which includes an effective audit committee of the board of
directors. The Commission asserted that “Audit Committees should be informed,
vigilant, and effective overseers of the financial reporting process and the com-
pany™s internal controls.”7
Ray Bromark and Ralph Hoffman note that the role of the audit committee is ex-
panding because of its value to the board of directors and to management and be-
cause of the need to meet the challenges of constantly changing business conditions.
They point out that the audit committee has the following primary responsibilities:

Assisting the board to fulfill its oversight responsibilities as they relate to the finan-
cial reporting process and the internal structure
Maintaining, by way of regularly scheduled meetings, direct lines of communication be-
tween the board, financial management, the independent accountant, and internal audit

Additional responsibilities include:

Reviewing corporate policies relating to compliance with laws and regulations,
ethics, conflict of interests, and the investigation of misconduct and fraud
Conducting periodic reviews of current pending litigation of regulatory proceedings
bearing on corporate governance in which the corporation is a party

5
Jeremy Bacon, The Audit Committee: A Broader Mandate, Report No. 914 (New York: The Confer-
ence Board, 1988), p. vii.
6
National Commission on Fraudulent Financial Reporting, Report of the National Commission on
Fraudulent Financial Reporting (Washington, DC: NCFFR, 1987), p. 40. This principle has become
statutory law under the Sarbanes-Oxley Act and the federal securities laws.
Moreover, a recent American Society of Corporate Secretaries study on current board practices
found in a survey of 804 companies that most respondents (85.6 percent) have no management direc-
tor on the audit committee (p. 12). In a subsequent survey of 648 companies, they found that such a
board practice continued to rank high among the most commonly adopted practices (p. 14). See
ASCS, Current Board Practices (New York: ASCS, 1996), and Current Board Practices, Second
Study (New York: ASCS, 1998).
7
NCFFR Report, p. 41.
Organization of the Audit Committee 45


Coordinating annual reviews of compliance with corporate governance policies
through internal audit or the company™s independent accountants
Performing or supervising special investigations
Reviewing executive expenses
Reviewing policies on sensitive payments
Reviewing past or proposed transactions between the corporation and members of
management
Reviewing the corporation™s benefits programs
Assessing the performance of financial management8


Making the Audit Committee Effective
To organize an effective and efficient audit committee, consideration should be
given to the proper delegation of responsibility and authority as well as to its writ-
ten charter, membership, and size.

As a prerequisite to the effec-
Delegation of Responsibility and Authority
tive performance of the committee, the board of directors should formulate a clear
definition of the committee™s responsibilities and authority. Moreover, the board
should either pass a formal resolution or amend the bylaws of the corporation in
order to document the establishment of the committee. Wayne Zetzman reports
that an audit committee can best serve a corporation when “it is a viable, inde-
pendent group with a definite mission and it has full access to the company™s fi-
nancial information.”9 One study noted that 51 companies with financial reporting
problems, namely Securities and Exchange Commission (SEC) enforcement ac-
tions and/or material misstatements of quarterly earnings, were much less likely to
have audit committees consisting solely of outside directors. Additionally, the re-
searchers found that accounting and finance knowledge as well as frequent meet-
ings are minimum steps needed to improve the quality in financial reporting.10 In
addition to both the internal and external auditors™ guidance and assistance, Zetz-
man notes that the chief financial officer must educate and guide the audit com-
mittee to enable it to serve the company effectively.11

8
Ray Bromark and Ralph Hoffman, “An Audit Committee for Dynamic Times,” Directors and Boards
16, No. 3 (Spring 1992), pp. 52, 53, 60.
9
Wayne Zetzman, “How to Organize and Use the Audit Committee,” Financial Executive 5, No. 4
(July/August 1989), p. 54.
10
See Dorothy A. McMullen and K. Raghunandan, “Enhancing Audit Committee Effectiveness,”
Journal of Accountancy 182, No. 2 (August 1996), pp. 79“81. Also see Eugene M. Katz, “Keys to an
Effective Audit Committee,” Credit World 86, No. 4 (March/April 1998), pp. 21“23; Krishnagopal
Menon and Joanne D. Williams, “The Use of Audit Committees for Monitoring,” Journal of Account-
ing & Public Policy 13, No. 2 (Summer 1994), pp. 121“139; F. Todd De Zoort, “An Investigation of
Audit Committees™ Oversight Responsibilities,” Abacus 33, No. 2 (September 1997), pp. 208“227;
Robert Lear, “The Decline of the Audit Committee,” Chief Executive, No. 111 (March 1996), p. 10;
William W. Warrick and Duncan J. Galloway, “The Governance Audit: How Can We Make Sure We
Don™t Get Surprised?” Directorship 22, No. 5 (May 1996), pp. 1“4.
11
Zetzman, “How to Organize and Use the Audit Committee,” p. 57.
46 Audit Committees: Basic Roles and Responsibilities


An example of the board™s delegation of responsibility and authority to the
audit committee is that of Wal-Mart Stores, Inc.:

BOARD COMMITTEES
Committee Members Functions and Additional Information
Audit Stanley C. Gault • Reviews financial reporting, policies, procedures,

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