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Furthermore, the committee should consider an integrated approach whereby its
plan is oriented toward the segments of the auditing cycle, which are: (1) initial
planning segment, (2) preaudit segment, and (3) postaudit segment. For example,
during the initial planning segment, it should develop a basic understanding of the
entity™s business and its industry. Such an understanding of the qualitative charac-
teristics of the entity and its position in the industry will enhance the committee™s
ability to discharge its responsibilities more effectively. In addition, during the
preaudit and postaudit segments, it should develop an understanding of manage-
ment™s business risk assessment process and the audit risk assessment process re-
lated to financial reporting risk as well as the analytical review process with
respect to the financial statements.

New Responsibilities under Sarbanes-Oxley (S-Ox) Act of 2002
S-Ox Section 201”Services Outside the Scope of Practice of Auditors
(a) PROHIBITED ACTIVITIES”Section 10A of the Securities Exchange Act of
1934 (15 U.S.C. 78j-1) is amended by adding at the end the following:
(g) PROHIBITED ACTIVITIES”Except as provided in subsection (h), it shall be
unlawful for a registered public accounting firm (and any associated person of that
firm, to the extent determined appropriate by the Commission) that performs for any
issuer any audit required by this title or the rules of the Commission under this title
or, beginning 180 days after the date of commencement of the operations of the Pub-
lic Company Accounting Oversight Board established under section 101 of the


28
The Business Roundtable, The Role and Composition of the Board of Directors of the Large Publicly
Owned Corporations, pp. 10“13.
29
See Chapters 6 and 7 for more information on the committee™s role in the planning function. It
should be noted that the chairman of the audit committee usually will ask the audit engagement part-
ner, the director of internal audit, and the chief financial officer to suggest agenda items for the com-
mittee meetings. These individuals are a major source of guidance and information to the committee.
In addition, it is essential that agenda and supporting documents are prepared and distributed in ad-
vance for each meeting.
62 Audit Committees: Basic Roles and Responsibilities


Sarbanes-Oxley Act of 2002 (in this section referred to as the “Board”), the rules of
the Board, to provide to that issuer, contemporaneously with the audit, any non-audit
service, including”
(1) bookkeeping or other services related to the accounting records or financial
statements of the audit client;
(2) financial information systems design and implementation;
(3) appraisal or valuation services, fairness opinions, or contribution-in-kind
reports;
(4) actuarial services;
(5) internal audit outsourcing services;
(6) management functions or human resources;
(7) broker or dealer, investment adviser, or investment banking services;
(8) legal services and expert services unrelated to the audit; and
(9) any other service that the Board determines, by regulation, is impermissible.
(h) PREAPPROVAL REQUIRED FOR NON-AUDIT SERVICES”A registered
public accounting firm may engage in any non-audit service, including tax services,
that is not described in any of paragraphs (1) through (9) of subsection (g) for an
audit client, only if the activity is approved in advance by the audit committee of the
issuer, in accordance with subsection (i).
(b) EXEMPTION AUTHORITY”The Board may, on a case-by-case basis, exempt
any person, issuer, public accounting firm, or transaction from the prohibition on the
provision of services under section 10A(g) of the Securities Exchange Act of 1934
(as added by this section), to the extent that such exemption is necessary or appro-
priate in the public interest and is consistent with the protection of investors, and sub-
ject to review by the Commission in the same manner as for rules of the Board under
section 107.30

S-Ox Section 202”Preapproval of Audit and Non-Audit Services
Section 10A of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1), as amended
by this Act, is amended by adding at the end the following:
(i) PREAPPROVAL REQUIREMENTS”
(1) IN GENERAL”
(A) AUDIT COMMITTEE ACTION”All auditing services (which may
entail providing comfort letters in connection with securities underwritings
or statutory audits required for insurance companies for purposes of State
law) and non-audit services, other than as provided in subparagraph (B), pro-
vided to an issuer by the auditor of the issuer shall be preapproved by the
audit committee of the issuer.
(B) DE MINIMUS EXCEPTION”The preapproval requirement under sub-
paragraph (A) is waived with respect to the provision of non-audit services
for an issuer, if”
(i) the aggregate amount of all such non-audit services provided to the
issuer constitutes not more than 5 percent of the total amount of rev-

30
Sarbanes-Oxley Act of 2002, H.R. Rep. No. 107-610, July 25, 2002.
The Audit Committee Functions 63


enues paid by the issuer to its auditor during the fiscal year in which the
nonaudit services are provided;
(ii) such services were not recognized by the issuer at the time of the en-
gagement to be non-audit services; and
(iii) such services are promptly brought to the attention of the audit
committee of the issuer and approved prior to the completion of the
audit by the audit committee or by 1 or more members of the audit com-
mittee who are members of the board of directors to whom authority to
grant such approvals has been delegated by the audit committee.
(2) DISCLOSURE TO INVESTORS”Approval by an audit committee of
an issuer under this subsection of a non-audit service to be performed by the
auditor of the issuer shall be disclosed to investors in periodic reports re-
quired by section 13(a).
(3) DELEGATION AUTHORITY”The audit committee of an issuer may
delegate to 1 or more designated members of the audit committee who are in-
dependent directors of the board of directors, the authority to grant preap-
provals required by this subsection. The decisions of any member to whom
authority is delegated under this paragraph to preapprove an activity under
this subsection shall be presented to the full audit committee at each of its
scheduled meetings.
(4) APPROVAL OF AUDIT SERVICES FOR OTHER PURPOSES”In
carrying out its duties under subsection (m)(2), if the audit committee of an
issuer approves an audit service within the scope of the engagement of the
auditor, such audit service shall be deemed to have been preapproved for pur-
poses of this subsection.31

S-Ox Section 203”Audit Partner Rotation
Section 10A of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1), as amended
by this Act, is amended by adding at the end the following:
( j) AUDIT PARTNER ROTATION”It shall be unlawful for a registered public ac-
counting firm to provide audit services to an issuer if the lead (or coordinating) audit
partner (having primary responsibility for the audit), or the audit partner responsible
for reviewing the audit, has performed audit services for that issuer in each of the 5
previous fiscal years of that issuer.32

S-Ox Section 204”Auditors™ Reports to Audit Committees
Section 10A of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1), as amended
by this Act, is amended by adding at the end the following:
(k) REPORTS TO AUDIT COMMITTEES”Each registered public accounting
firm that performs for any issuer any audit required by this title shall timely report to
the audit committee of the issuer”
(1) all critical accounting policies and practices to be used;
(2) all alternative treatments of financial information within generally accepted
accounting principles that have been discussed with management officials of the

31
Ibid., Sec. 202.
32
Ibid., Sec. 203.
64 Audit Committees: Basic Roles and Responsibilities


issuer, ramifications of the use of such alternative disclosures and treatments, and
the treatment preferred by the registered public accounting firm; and
(3) other material written communications between the registered public ac-
counting firm and the management of the issuer, such as any management letter
or schedule of unadjusted differences.33


S-Ox Section 206”Conflicts of Interest
Section 10A of the Securities Exchange Act of 1934 (15 U.S.C. 78j-1), as amended
by this Act, is amended by adding at the end the following:
(l) CONFLICTS OF INTEREST”It shall be unlawful for a registered public ac-
counting firm to perform for an issuer any audit service required by this title, if a chief
executive officer, controller, chief financial officer, chief accounting officer, or any per-
son serving in an equivalent position for the issuer, was employed by that registered in-
dependent public accounting firm and participated in any capacity in the audit of that
issuer during the 1-year period preceding the date of the initiation of the audit.34

S-Ox Section 403”Disclosure of Transactions Involving Management
and Principal Stockholders
(a) AMENDMENT”Section 16 of the Securities Exchange Act of 1934 (15 U.S.C.
78p) is amended by striking the heading of such section and subsection (a) and in-
serting the following:

SEC. 16. DIRECTORS, OFFICERS, AND PRINCIPAL STOCKHOLDERS.
(a) DISCLOSURES REQUIRED”
(1) DIRECTORS, OFFICERS, AND PRINCIPAL STOCKHOLDERS RE-
QUIRED TO FILE”Every person who is directly or indirectly the beneficial
owner of more than 10 percent of any class of any equity security (other than an
exempted security) which is registered pursuant to section 12, or who is a direc-
tor or an officer of the issuer of such security, shall file the statements required by
this subsection with the Commission (and, if such security is registered on a na-
tional securities exchange, also with the exchange).
(2) TIME OF FILING”The statements required by this subsection shall be
filed”
(A) at the time of the registration of such security on a national securities ex-
change or by the effective date of a registration statement filed pursuant to
section 12(g);
(B) within 10 days after he or she becomes such beneficial owner, director,
or officer;
(C) if there has been a change in such ownership, or if such person shall have
purchased or sold a security-based swap agreement (as defined in section
206(b) of the Gramm-Leach-Bliley Act (15 U.S.C. 78c note)) involving such
equity security, before the end of the second business day following the day
on which the subject transaction has been executed, or at such other time as


33
Ibid., Sec. 204.
34
Ibid., Sec. 206.
The Audit Committee Functions 65


the Commission shall establish, by rule, in any case in which the Commis-
sion determines that such 2-day period is not feasible.
(3) CONTENTS OF STATEMENTS”A statement filed”
(A) under subparagraph (A) or (B) of paragraph (2) shall contain a statement
of the amount of all equity securities of such issuer of which the filing per-
son is the beneficial owner; and
(B) under subparagraph (C) of such paragraph shall indicate ownership by
the filing person at the date of filing, any such changes in such ownership,
and such purchases and sales of the security-based swap agreements as have
occurred since the most recent filing under such subparagraph.
(4) ELECTRONIC FILING AND AVAILABILITY”Beginning not later than 1
year after the date of enactment of the Sarbanes-Oxley Act of 2002”
(A) a statement filed under subparagraph (C) of paragraph (2) shall be filed
electronically;
(B) the Commission shall provide each such statement on a publicly acces-
sible Internet site not later than the end of the business day following that fil-
ing; and
(C) the issuer (if the issuer maintains a corporate website) shall provide that
statements on that corporate website, not later than the end of the business
day following that filing.
(b) EFFECTIVE DATE”The amendment made by this section shall be effective 30
days after the date of the enactment of this Act.35

S-Ox Section 404”Management Assessment of Internal Controls
(a) RULES REQUIRED”The Commission shall prescribe rules requiring each an-
nual report required by section 13(a) or 15(d) of the Securities Exchange Act of 1934
(15 U.S.C. 78m or 78o(d)) to contain an internal control report, which shall”
(1) state the responsibility of management for establishing and maintaining an
adequate internal control structure and procedures for financial reporting; and
(2) contain an assessment, as of the end of the most recent fiscal year of the is-
suer, of the effectiveness of the internal control structure and procedures of the is-
suer for financial reporting.
(b) INTERNAL CONTROL EVALUATION AND REPORTING”With respect to
the internal control assessment required by subsection (a), each registered public ac-
counting firm that prepares or issues the audit report for the issuer shall attest to, and
report on, the assessment made by the management of the issuer. An attestation
made under this subsection shall be made in accordance with standards for attesta-
tion engagements issued or adopted by the Board. Any such attestation shall not be
the subject of a separate engagement.36

S-Ox Section 406”Code of Ethics for Senior Financial Officers
(a) CODE OF ETHICS DISCLOSURE”The Commission shall issue rules to re-
quire each issuer, together with periodic reports required pursuant to section 13(a) or

35
Ibid., Sec. 403.
36
Ibid., Sec. 404.
66 Audit Committees: Basic Roles and Responsibilities


15(d) of the Securities Exchange Act of 1934, to disclose whether or not, and if not,
the reason therefor, such issuer has adopted a code of ethics for senior financial
officers, applicable to its principal financial officer and comptroller or principal ac-
counting officer, or persons performing similar functions.
(b) CHANGES IN CODES OF ETHICS”The Commission shall revise its regula-
tions concerning matters requiring prompt disclosure on Form 8-K (or any succes-
sor thereto) to require the immediate disclosure, by means of the filing of such form,
dissemination by the Internet or by other electronic means, by any issuer of any
change in or waiver of the code of ethics for senior financial officers.
(c) DEFINITION”In this section, the term “code of ethics” means such standards
as are reasonably necessary to promote”
(1) honest and ethical conduct, including the ethical handling of actual or ap-
parent conflicts of interest between personal and professional relationships;
(2) full, fair, accurate, timely, and understandable disclosure in the periodic re-
ports required to be filed by the issuer; and
(3) compliance with applicable governmental rules and regulations.
(d) DEADLINE FOR RULEMAKING”The Commission shall”
(1) propose rules to implement this section, not later than 90 days after the date
of enactment of this Act; and
(2) issue final rules to implement this section, not later than 180 days after that
date of enactment.37

Obviously, the audit committee cannot participate
The Monitoring Function
in the accounting and auditing functions on a day-to-day basis, because such a task
is contrary to its overall purpose. However, since the board of directors has the ul-

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