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these people. . . . They add balance to a committee.16

Thus, a committee that has members with diverse backgrounds is advantageous
since it provides the audit committee with the kind of perspective and experience
desirable in assessing both the internal and external audit functions.
Equally important, the chairman has a critical role in coordinating the commit-
tee™s task. The success or failure of the operation could depend on the chairman,
and therefore such an individual should be chosen with great care. Specifically, the
chairman should possess the same basic qualifications listed earlier as well as:

• The ability to stimulate the audit directors™ thinking without dominating the
• The ability to retain not only each member™s personal interest in the work of
the committee but also the willingness to contribute to its objectives
• A general understanding of the objectives and jurisdictional aspects
• The ability to plan the agenda and to coordinate and disseminate information
to the committee and the board members

In a study of 42 publicly held companies dealing with leadership styles of
audit committee effectiveness, William D. Spangler and Louis Braiotta, Jr., report
that transformational leadership and active management by exception have a sub-
stantial impact on the performance of audit committees. They found that “correla-
tions of transformational leadership (charisma, intellectual stimulation, and
individualized considerations), contingent rewards, and active management by ex-
ception with effectiveness were significant in the predicted positive direction and
passive management by exception was nonstatistically related to audit committee
effectiveness as predicted.”17 Their findings and conclusions were based on
Bernard M. Bass™s theoretical leadership perspective, which states: “Transforma-
tional leadership is somewhat independent of organizational structure and relies on
the personality, beliefs, and behavior of leaders and subordinates. Indeed, trans-
formational leaders are likely to emerge in times of crises when traditional orga-
nizational and social structures and values are weak.”18

Ernst & Whinney, E&W People Booklet No. 46302, Cleveland, OH. (1980), p. 7.
William D. Spangler and Louis Braiotta, Jr., “Leadership and Audit Committee Effectiveness,”
Group and Organization Studies 15, No. 2 (June 1990), p. 134. See also Lawrence Kalbers and Timo-
thy J. Fogarty, “Organizational and Economic Explanations of Audit Committee Oversight,” Journal
of Managerial Issues 10, No. 2 (Summer 1998), pp. 129“150.
Bernard M. Bass, Leadership and Performance Beyond Expectations (New York: Free Press, 1985),
p. 37.
Organization of the Audit Committee 57

With respect to the size of the audit committee, the American Institute of Cer-
tified Public Accountants indicates that:

A survey of corporations with audit committees revealed that nearly 90 percent had
audit committees of three to five members. In general, the audit committee should be
large enough to have members with a good mix of business judgment and experi-
ence, but not so large as to be unwieldy.19

This survey is further supported by the Conference Board survey, which reports
that the median sizes are now 4 members for manufacturing and nonfinancial ser-
vice companies and 4.5 for financial firms.20
Although there is general consensus regarding the size, obviously, the number
of members will vary from corporation to corporation. The number of members
depends not only on the committee™s responsibility and authority but also on the
size of both the board of directors and the corporation. For example, Wal-Mart
Stores, Inc., has 14 members on the board of directors. Ten are nonemployee di-
rectors, including three who are members of the audit committee. Furthermore,
Wal-Mart™s audit committee members are individuals from the fields of commu-
nications and industry.21

Financial Expert
Section 407 of the Sarbanes-Oxley Act provides that:

(a) RULES DEFINING “FINANCIAL EXPERT””The Commission shall issue
rules, as necessary or appropriate in the public interest and consistent with the pro-
tection of investors, to require each issuer, together with periodic reports required
pursuant to sections 13(a) and 15(d) of the Securities Exchange Act of 1934, to dis-
close whether or not, and if not, the reasons therefor, the audit committee of that is-
suer is comprised of at least 1 member who is a financial expert, as such term is
defined by the Commission.
(b) CONSIDERATIONS”In defining the term “financial expert” for purposes of
subsection (a), the Commission shall consider whether a person has, through educa-
tion and experience as a public accountant or auditor or a principal financial officer,
comptroller, or principle accounting officer of an issuer, of from a position involving
the performance of similar functions”
(1) an understanding of generally accepted accounting principles and financial
(2) experience in”
(A) the preparation or auditing of financial statements of generally compa-
rable issuers; and
(B) the application of such principles in connection with the accounting for
estimates, accruals, and reserves;

American Institute of Certified Public Accountants, Audit Committees, p. 12.
Bacon, The Audit Committee: A Broader Mandate, p. 5.
Wal-Mart Stores, Inc., Notice of Annual Meeting of Stockholders, June 6, 3003, pp. 2“3.
58 Audit Committees: Basic Roles and Responsibilities

(3) experience with internal accounting controls; and
(4) an understanding of audit committee functions.22

Audit Committee Meetings
Although the Sarbanes-Oxley Act does not address audit committee meetings, the
New York Stock Exchange issued a proposed rule change that states:

Meet separately, periodically, with management, with internal Auditors (or other per-
sonnel responsible for the internal audit Function) and with independent auditors.23

Furthermore, the National Commission on Fraudulent Financial Reporting rec-
ommended the “audit committee oversight responsibilities undertakes on behalf of
the board of directors extend to the quarterly reporting process. The audit com-
mittee should review the controls that management has established to protect the
integrity of the quarterly reporting process. This review should be ongoing.”24

Audit Committee Functions as Defined
by the American Bar Association
The Committee on Corporate Laws of the American Bar Association has defined
the functions of the audit committee in this way:

In its capacity as the communication link between the board of directors as repre-
sentative of stockholders, on the one hand, and the independent auditors, on the
other hand, the audit committee should have prime responsibility for the discharge
of at least the following four functions:
1. To recommend the particular persons or firm to be employed by the corporation
as its independent auditors;
2. To consult with the persons so chosen to be the independent auditors with regard
to the plan of audit;
3. To review, in consultation with the independent auditors, their report of audit, or
proposed report of audit, and the accompanying management letter, if any; and
4. To consult with the independent auditors (periodically, as appropriate, out of the
presence of management) with regard to the adequacy of internal controls, and if
need be, to consult also with the internal auditors (since their product has a strong
influence on the quality and integrity of the resulting independent audit).25

Sarbanes-Oxley Act of 2002, H.R. Rep. No. 107-610, July 25, 2002. See also SEC Release No. 33-
8177, January 23, 2003.
Securities and Exchange Commission Release No. 34-47672, File No. SR-NYSE-2002-33 Proposed
Rule Change Relating to Corporate Governance (April 11, 2003), p. 13.
National Commission on Fraudulent Financial Reporting, Report of the National Commission on
Fraudulent Reporting (Washington, DC: NCFFR, 1987), p. 48.
American Bar Association, Corporate Director™s Guidebook (Chicago: ABA, 1978), pp. 32“33.
The Audit Committee Functions 59

Subsequently, the Committee on Corporate Laws expanded its definitions to in-
clude in substantial part the American Law Institute™s Principles of Corporate

1. Recommend which firm to engage as the corporation™s external auditor and
whether to terminate that relationship.
2. Review the external auditor™s compensation, the proposed terms of its engage-
ment, and its independence.
3. Review the appointment and replacement of the senior internal auditing execu-
tive, if any.
4. Serve as a channel of communication between the external auditor and the board
and between the senior internal auditing executive, if any, and the board.
5. Review the results of each external audit, including any qualifications in the ex-
ternal auditor™s opinion, any related management letter, management™s re-
sponses to recommendations made by the external auditor in connection with
the audit, reports submitted to the Audit Committee by the internal auditing de-
partment that are material to the corporation as a whole, and management™s re-
sponses to those reports.
6. Review the corporation™s annual financial statements and any significant dis-
putes between management and the external auditor that arose in connection
with the preparation of those financial statements.
7. Consider, in consultation with the external auditor and the senior internal audit-
ing executive, if any, the adequacy of the corporation™s internal financial con-
trols. Among other things, these controls must be designed to provide reasonable
assurance that the corporation™s publicly reported financial statements are pre-
sented fairly in conformity with generally accepted accounting principles.
8. Consider major changes and other major questions of choice regarding the ap-
propriate auditing and accounting principles and practices to be followed when
preparing the corporation™s financial statements.
9. Review the procedures employed by the corporation in preparing published fi-
nancial statements and related management commentaries.
10. Meet periodically with management to review the corporation™s major financial
risk exposures.26

In addition to the American Bar Association™s definition on the function of the
audit committee, the National Commission on Fraudulent Financial Reporting
recommends these functions:

As part of its ongoing oversight of the effectiveness of internal controls, a company™s
audit committee should review annually the program management establishes to
monitor compliance with the code of conduct. (p. 35)
All public companies should develop a written charter setting forth the duties and re-
sponsibilities of the audit committee. The board of directors should approve the
charter, review it periodically, and modify it as necessary. (p. 42)

American Bar Association, Corporate Director™s Guidebook (Chicago: ABA, 1994), pp. 28“29.
60 Audit Committees: Basic Roles and Responsibilities

Audit committees should have adequate resources and authority to discharge their re-
sponsibilities. (p. 43)
Audit committees should oversee the quarterly reporting process. (p. 47)
Management and the audit committee should ensure that the internal auditors™ in-
volvement in the audit of the financial reporting process is appropriate and properly
coordinated with the independent public accountant. (p. 39)
The audit committee should review management™s evaluation of factors related to the
independence of the company™s public accountant. Both the audit committee and man-
agement should assist the public accountant in preserving his independence. (p. 43)
Before the beginning of each year, the audit committee should review management™s
plans for engaging the company™s independent public accountant to perform man-
agement advisory services during the coming year, considering both the types of ser-
vices that may be rendered and the projected fees. (p. 43)
All public companies should be required by SEC rule to include in their annual re-
port to stockholders a letter signed by the chairman of the audit committee describ-
ing the committee™s responsibilities and activities during the year. (p. 46)
Management should advise the audit committee when it seeks a second opinion on
a significant accounting issue. (p. 47)27

Basic Audit Committee Functions
In addition to the preceding conclusions on the functions of the audit committee,
the basic functions should include:

• The planning function
• The monitoring function
• The reporting function

Since the primary objective of the committee is to
The Planning Function
oversee and monitor the financial accounting and auditing processes, it should
adopt its own coordinated plan of administration that is consistent with this ob-
jective. Such a plan should be designed to provide assurance to the full board of
directors that both the internal and external resources allocated to the audit func-
tion are adequate and used effectively. The Committee on Corporate Organization
Policy of The Business Roundtable agreed on two core functions of the board that
are directly related to the committee™s planning function:

1. Although the board cannot effectively conduct day-to-day operations, the board
does have a major role in, and a major accountability for, the financial perfor-
mance of the enterprise. This clearly requires a continuing check on corporate fi-
nancial results and prospects.

NCFFR, Report of the National Commission on Fraudulent Financial Reporting, 1987. For further
discussion, see the Committee of Sponsoring Organizations of the Treadway Commission (COSO),
International Control-Integrated Framework 4, COSO of the Treadway Commission (1992), pp.
The Audit Committee Functions 61

2. Directors and top management cannot be the guarantors of the lawful conduct of
every employee or manager in a large organization. . . . Policies and procedures
should be designed to promote corporate law compliance.28

Thus, in view of the committee™s oversight and advisory capacity, its plan
should include:

• A review and appraisal of the overall purpose, objectives, and resources avail-
able for the entity™s overall audit plan in accordance with the committee™s char-
ter as well as the committee™s recommendation of the audit goals and
objectives to the board for its approval
• A review and consolidation of the audit plans of the internal and external au-
diting groups
An appraisal of the corporate audit plan annually29


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