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Standards Board, Statement on Auditing Standards, Statement on
Standards for Attestation Engagements, and Accounting Standards
Executive Committee Pronouncements as of June 30, 2003, 405
B Professional Accounting Associations, Business Organizations, Boards,
Commissions, and Directors Publications, 413

Appendixes C“J are available on The Audit Committee Handbook
website at www.wiley.com/go/auditcommittee.


INDEX 417
Preface

Since the publication of the third edition of The Audit Committee Handbook in
1999, a number of major accounting scandals (e.g., Enron, WorldCom, and others)
as well as the demise of the international accounting firm of Anderson LLP have
shaken the global capital markets. As a result, the U.S. Congress enacted the Sar-
banes-Oxley Act of 2002 and the Securities and Exchange Commission adopted
final rules amending the securities laws. Likewise, the Self-Regulatory Organiza-
tions set forth a number of amendments to their listing standards with respect to
corporate governance and accountability. The major thrust of these reforms is to
create a new regulatory and legal environment and corporate accountability frame-
work, which, in turn, provides an effective financial reporting system with relevant
and reliable financial information. The primary goal is to restore investor confi-
dence through an efficient securities market system.
Historically, the role and responsibilities of the audit committee as a key insti-
tution in corporate governance has been accepted as an important oversight mech-
anism to help the board of directors discharge its fiduciary financial responsibility
and stewardship accountability to the shareholders. However, the aforementioned
events have caused a reexamination of the audit committee™s role in the context of
corporate governance. In fact, these events have caused a number of best practices
for the audit committee to become federal statute. Given these mandates, members
of audit committees must adhere to higher standards in corporate accountability to
ensure the quality of financial information and investor protection against ac-
counting scandals. Audit committees in a global securities marketplace continue to
respond to the investing public™s demand for oversight protection. (See Appendix D
on this book™s website.) As noted, such committees not only help engender a high
degree of integrity in both the internal and external audit processes and financial
reporting process, but they also help provide for an efficient and transparent secu-
rities market. For example, many countries with developed equity markets or
emerging markets have adopted audit committees through public and/or private
sector initiatives to ensure price protection of their securities to investors. More-
over, the recent initiatives to develop and adopt harmonized international ac-
counting and auditing standards accentuate the need to achieve uniformity in
oversight protection to investors. It should be noted that companies will use the en-
dorsement of these standards by the International Organization of Securities Com-
missions in their stock offering documents to raise capital in a global securities
marketplace.

xv
xvi Preface


Although many countries have recognized that the establishment and benefits
of audit committees help to ensure integrity in the corporate accountability
process, it is imperative that such committees conduct their activities in an effi-
cient and effective manner to help their boards of directors discharge their finan-
cial and fiduciary responsibilities to stockholders. As noted in the text, the recent
enactment of the Sarbanes-Oxley Act of 2002 will influence significantly how
boards of directors through their audit committees can meet their oversight re-
sponsibilities in both the auditing and financial reporting areas. This fourth edition
provides comprehensive guidance to all functions, duties, and responsibilities of
audit committees as well as their direction in the corporate governance context. It
retains the thrust of the third edition, focusing on current trends and developments
that maximize the effectiveness of audit committees. Numerous references are
made to the pronouncements of leading organizations in both the public and pri-
vate sectors to bring an element of authority to the handbook.
Recognizing that audit committees interact with the internal auditor, indepen-
dent auditor, chief financial officer, internal legal counsel, and independent legal
counsel, the fourth edition continues to offer practical guidance in developing a
constructive relationship between the committees™ jurisdictional responsibilities
and the activities of these executives. This revised professional reference work en-
ables the aforementioned parties to help audit committees plan their agendas and
achieve their mission in corporate governance. It provides a perspective that will
help the members of the audit committee develop the appropriate requisite knowl-
edge with respect to such matters as:

• Understanding the role and responsibilities of the audit committee with a gen-
eral update and reality check on auditing cycle activities.
• Identifying the developments that impact audit committee practices and the lat-
est techniques and strategies for committee meetings.
• Understanding the latest authoritative sources that enable audit committee
members to develop a repertoire of effective strategies to help the board of di-
rectors discharge its fiduciary responsibility to the stockholders.
• Developing a comprehensive professional development program that enables
committee members to prepare a periodic assessment of their activities and an
informed review of both audit processes and financial reporting process.
• Understanding the legal aspects of the audit committee and role of legal coun-
sel as well as fraudulent financial reporting.

The book is divided into four parts. Part 1 includes a discussion on corporate
accountability, the audit committee™s basic roles and responsibilities, the external
users of accounting information, and the legal position of the audit committee. In
addition, the broad framework of generally accepted auditing standards and their
integration with generally accepted accounting principles are dealt with in one
chapter to show their interrelationship.
Part 2 covers the planning function of the audit committee. An initial overview
of the concept of audit planning is presented and followed with a discussion of the
Preface xvii


audit director™s role in planning the audit. This part includes a discussion of the se-
lection or reappointment of the public accounting firm.
Part 3 describes the monitoring and reviewing functions of the audit commit-
tee. Here the book focuses on the system of internal control, the internal audit
function, accounting policy disclosures, fraud and the auditor, and sensitive busi-
ness practices.
Part 4 covers the reporting function of the audit committee. Special attention
initially is given to an overview of the independent auditor™s opinions and reports.
The final chapter explains the purpose of the audit committee™s report and dis-
cusses the guidelines for preparing it.
This book seeks to provide useful information and guidance for the audit
committee and to point out opportunities for auditors and management to better
serve the audit committee.


LOUIS BRAIOTTA, JR., C.P.A.
Binghamton, New York
Acknowledgments

I want to express my appreciation to Dr. Upinder Dhillon, dean of the School of
Management of Binghamton University (State University of New York), for his
encouragement in the preparation of the manuscript. Also, I want to thank my fac-
ulty colleagues, accounting practitioners, and students for their encouragement
and support.
I am grateful to the American Institute of Certified Public Accountants, the In-
stitute of Internal Auditors, the American Bar Association, and the Association of
Certified Fraud Examiners for their permission to use certain materials subject to
their copyrights.
My sincere thanks to Bernie Cencetti for her fine typing work and to Colleen
Hailey, associate librarian. My thanks to the people at John Wiley & Sons for their
production and editorial assistance.




xix
Part One
Getting Acquainted
with Your
Responsibilities
Chapter 1
Corporate Accountability:
The New Environment

To properly understand the importance of the corporate director™s position on the
audit committee, one must understand the nature and importance of the concept of
corporate accountability in the new legal and regulatory framework under statu-
tory law. Therefore, the major objectives of this chapter are: first, to revisit the
meaning and significance of corporate accountability; second, to explain the sig-
nificance of major audit committee developments in the context of corporate ac-
countability with special emphasis on those of the past five years; and third, to
show the impact of corporate accountability on the audit committee and its cor-
porate relationships.
Although the recent failures of major corporations, such as Enron, WorldCom,
and others, have accelerated the need for legal and regulatory reforms, the concept
and meaning of corporate accountability in relation to the institution of the audit
committee remains the same both before and after accounting scandals. However,
with the enactment of the Sarbanes-Oxley Act of 2002, the substantive meaning of
corporate accountability has caused many best practices for audit committees to
become statutory law. Moreover, the new legislation has caused an institutional re-
structuring of the accounting profession as well as additional resources for the Se-
curities and Exchange Commission (SEC) to curb abuses of fraudulent financial
reporting.


THE NATURE AND IMPORTANCE
OF CORPORATE ACCOUNTABILITY
The Meaning of Corporate Accountability
With the recent establishment of the Public Company Accounting Oversight Board
(PCAOB) with its oversight and enforcement authority over the independent audit
process and the concomitant effect on strengthening the institution of the audit
committee, it is reasonable to expect that shareholders and other constituencies of
corporations will receive relevant and reliable financial information. Thus, such
congressional legislative action will help to ensure an efficient capital market sys-
tem. As James S. Turley, chairman and chief executive officer of Ernst & Young
LLP, points out;

The biggest problem today is the loss of confidence, in not just our profession, but
in financial management, executive management. audit committees and boards.

3
4 Corporate Accountability: The New Environment


[While] I see no silver bullet to turn that around, I think it is going to be turned
around by sustained, outstanding performance, high quality [and] high integrity by
all parties”management, audit committees, audit firms.1

Strictly speaking, the concept of corporate accountability may be stated in
this way:

The board of directors is charged with safeguarding and advancing the interest of the
stockholders, acting as their representatives in establishing corporate policies, and
reviewing management™s execution of those policies. Accordingly, the directors have
a fiduciary responsibility to the stockholders. They have an obligation to inform
themselves about the company™s affairs and to act diligently and capably in fulfilling
their responsibilities.2

The board of directors is charged with protecting the interests of the stock-
holders because the position of the board is determined by state laws. The powers
and responsibilities of the board are defined in the corporate charter and the cor-
porate bylaws. Therefore, from a legal point of view, the basic purpose of corpo-
rate accountability is to provide a legal framework within which the directors must
discharge their stewardship accountability to the stockholders. Furthermore, the
board is directly answerable to the stockholders because the stockholders, as the
owners of the enterprise, have entrusted their capital resources to the management
of the corporation. (See Appendix H on this book™s website.)
The Business Roundtable described corporate accountability in this way:

The board of directors is ultimately accountable to the shareholders for the long-term
successful economic performance of the corporation consistent with its underlying
public purpose. Directors are held accountable for their performance in a variety of
ways.
First, there is the powerful accountability imposed by markets. The impact of con-
sumer dissatisfaction with products and services is quick and visible. Financial mar-
kets also quickly reflect their evaluation of the quality of accountability through the
price of equity and debt.
Accountability is also imposed through the numerous statutes and regulations en-
acted by governmental bodies to limit and control corporate action. Directors are
held accountable to regulatory mechanisms.
There is also a body of law”part statutory, part court-made”which defines the du-
ties of directors and the principles and boundaries within which they must keep their
decisions. If they overstep, their decisions are subject to reversal by the courts. Di-
rectors can also be held personally liable, without limitation, to the extent of their
personal assets if they violate their duty of loyalty to the corporation.
A final form of board accountability comes through the election of directors by the
shareholders at the corporation™s annual meeting. Annual meetings may also include
shareholder resolutions which are a form of governance by referendum.

1
James S. Turley, “The Future of Corporate Reporting: From the Top,” Financial Executive 70 (De-
cember 2002), p. 2.
2
American Institute of Certified Public Accountants, Audit Committees, Answers to Typical Questions
about Their Organization and Operations (New York: AICPA, 1978), p. 7.
The Nature and Importance of Corporate Accountability 5


Each of these forms of accountability is dynamic, not static. The developing specifics
of each form of accountability must be judged as to its overall potential to contribute
to the successful long-term performance of the corporation. Each specific new item
of accountability carries with it the potential for harm as well as good.3

More recently, the Business Roundtable restated its guiding principles of cor-
porate governance:
First, the paramount duty of the board of directors of a public corporation is to select
a chief executive officer and to oversee the CEO and other senior management in the
competent and ethical operation of the corporation on a day-to-day basis.
Second, it is the responsibility of management to operate the corporation in an effec-
tive and ethical manner in order to produce value for stockholders. Senior management
is expected to know how the corporation earns its income and what risks the corpora-
tion is undertaking in the course of carrying out its business. Management should
never put personal interests ahead of or in conflict with the interests of the corporation.
Third, it is the responsiblity of management, under the oversight of the board and its
audit committee, to produce financial statements that fairly present the financial
condition and results of operations of the corporation, and to make the timely dis-
closures investors need to permit them to assess the financial and business soundness
and risks of the corporation.
Fourth, it is the responsibility of the board and its audit committee to engage an in-
dependent accounting firm to audit the financial statements prepared by management
and to issue an opinion on those statements based on Generally Accepted Account-
ing Principles. The board, its audit committee, and management must be vigilant to
ensure that no actions are taken by the corporation or its employees that compromise
the independence of the outside auditor.
Fifth, it is the responsibility of the independent accounting firm to ensure that it is in
fact independent, is without conflicts of interest, employs highly competent staff, and
carries out its work in accordance with Generally Accepted Auditing Standards. It is
also the responsibility of the independent accounting firm to inform the board,
through the audit committee, of any concerns the auditor may have about the appro-

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