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The preceding discussions on the operational objectives and the criteria for
evaluating the usefulness of the financial statements provide the necessary guide-
lines for evaluating management™s responsibilities in the preparation of the finan-
cial statements. In addition, the audit committee should give consideration to the
following criteria, which were used by the Financial Analysts Federation in its
Awards for Excellence in Corporate Reporting program:

1. Responsiveness of management to analysts™ and investors™ desire for information
prerequisite to real understanding of companies and their problems.
2. Efforts by companies to supply financial and other information going well be-
yond the level of disclosure required by the SEC, the exchanges, and the FASB.
3. A coordinated and consistent program of personal contact with investors and
their representatives”both through provision of experienced and helpful officials
in the investor relations function and via regular management presentations to an-
alyst groups, company-sponsored field trips, and so on.
4. A high “candor quotient” in both oral and written communications to the invest-
ment community. Too many managements prejudice an otherwise creditable in-
formation program by ignoring or glossing over unfavorable developments with
a thick patina of corporate optimism.26

Subsequently, the Association for Investment Management and Research is-
sued its Corporate Information Committee Report (1995“1996). A checklist of cri-
teria for evaluating financial communications effort stated in part:


Annual Published Information
A. Annual Report
1. Financial Highlights: Are they clear and unambiguous?
2. President™s Letter Review: Does it hit the highlights of the year in an objective manner?
Is it relevant to the company™s results and candid in appraising problems? It should
include:
a. Review of the year.
b. Insights into operating rates, unit production levels, and selling prices.
c. Acquisitions and divestments, if any.
d. Government business, if material.
e. Capital expenditures program; start-up expenses.
f. Research and development efforts.
g. Employment costs, labor relations, union contracts.
h. Energy cost and availability.
i. Environmental and OSHA costs.
j. Backlogs.
k. New products.
l. Legislative and regulatory developments.
m. Outlook.
n. Unusual income or expense.
3. Officers and Directors:
a. Age, background, and responsibilities.


26
Financial Analysts Federation, “Awards for Excellence in Corporate Reporting,” Financial Analysts
Federation News Release (New York: FAF, January 1978), p. 1.
The Investors 107


b. Description of company organization.
c. Outside affiliations of directors.
d. Principal personnel changes.
4. Statement of Corporate Goals:
What are the short-term and long-term corporate goals, and how and when does man-
agement expect to achieve them? (This section could be included in several areas of the
report, but separate treatment is preferred.)
5. Discussions of Divisional and/or Segment Operations:
a. How complete is the breakdown of sales, materials, costs, overhead, and earnings?
b. Are the segments logical for analytical purposes? Do they parallel lines of business?
c. Are unusual developments explained, and do the explanations include manage-
ment™s response?
d. Comparisons with relevant industry developments should include:
i. Market size and growth.
ii. Market penetration.
iii. Geographical divergencies.
e. Foreign operations:
i. Revenues, including export sales.
ii. Consolidated foreign earnings versus equity interest.
iii. Market and/or regional trends.
iv. Tax status.
6. Financial Summary and Footnotes:
a. Statement of accounting principles, including explanation of changes and their
effects.
b. Adjustments to EPS for dilution.
c. Affiliates™ operating information.
d. Consolidated finance subsidiary™s disclosure of separate balance sheet information
and operating results.
e. Cash flow statement (FAS No. 95).
f. Tax accounting investment tax credits identified, breakdown of current and deferred
taxes for U.S. and non-U.S. tax jurisdictions, reconciliation of effective and statu-
tory tax rates, impact of changes in tax law, early application of FAS No. 96.
g. Clarity of explanation of currency exchange rate accounting:
i. Impact on earnings from Balance Sheet translation, if any.
ii. Indication of “Operating” or Income Statement Effect of exchange rate fluctuations.
h. Property accounts and depreciation policies:
i. Methods and asset lives used for tax and for financial reporting.
ii. Quantification of effect on reported earnings of use of different method and/or
asset lives for tax purposes.
i. Investments: composition and market values disclosed.
j. Inventories: method of valuation and identifying different methods for various
product or geographic segments.
k. Leases and rentals: terms and liability.
l. Debt repayment schedules.
m. Pension funds: costs charged to income, interest rate, and wage-inflation assump-
tions; amount of any unfunded past service liability; amortization period for un-
funded liability (FAS No. 87).
n. Other postemployment benefits: pay-as-you-go amount, discussion of potential
liability, impact of FAS No. 106, including plans to fund or amend, and impact of
FAS No. 112.
o. Capital expenditure programs and forecasts, including costs for environmental
purposes.
p. Acquisitions and divestitures (if material):
i. Description of activity and operating results.
108 The External Users of Accounting Information


ii. Type of financial transaction.
iii. Effect on reported sales and earnings.
iv. Quantification of purchase acquisitions or small poolings that do not require
restatement of prior years™ results. (When restating for pooling, both old and new
data are useful for comparison.)
q. Year-end adjustments.
r. Restatement of quarterly reports to year-end accounting basis.
s. Research and development and new products; amount and types of outlays and
forecasts.
t. Contingent liabilities, particularly environmental.
u. Derivation of number of shares used for calculating primary and fully diluted earn-
ings per share.
v. Disclosures of the fair values of financial instruments (FAS No. 107).
w. Goodwill amount being amortized and number of years.
x. Ten-year statistical summary:
i. Adequacy of income statement and balance sheet detail.
ii. Helpfulness of “nonstatement” data (e.g., number of employees, adjusted num-
ber of shares, price of stock, capital expenditures, etc.)
B. 10-Ks, 10-Qs, and Other Required Published Information


Quarterly and Other Published Information Not Required
A. Quarterly Reports
1. Depth of commentary on operating results and developments.
2. Discussion of new products, management changes, and problem areas.
3. Degree of detail of profit and loss statement, including divisional or segmental break-
down.
4. Inclusion of a balance sheet and cash flow statement.
5. Restatement of all prior- and current-year quarters for major pooling acquisitions and
quantification of effect of purchase acquisitions and/or disposals.
6. Breakout of nonrecurring or exceptional income or expense items, including effects
from inventory valuation and foreign currency translation factors.
7. Explicit statement of accounting principles underlying quarterly statements.
8. Timeliness of reports.
9. Separate fourth quarter report.
B. Other Published Material
1. Availability of proxy statements (even though this is required public information).
2. Annual meeting report; available with questions and answers and identity of those
posing questions.
3. Addresses to analysts™ groups: available with questions and answers.
4. Statistical supplements and fact books.
5. Company magazines, newsletters, and explanatory pamphlets.
6. Press releases: Are they sent to shareholders and analysts? Are they timely? Do they
include earnings numbers?
7. How are documents filed with public agencies (SEC, Federal Trade Commission,
Department of Labor, court cases, etc.) made available? Does the company disseminate
all material information in 10-K, 10-Q, and similar reports?


Other Aspects
A. Is there a designated and advertised individual (or individuals) for shareholder and analyst
contacts?
B. Interviews
The Investors 109


1. Knowledgeability and responsiveness of company contact.
2. Access to policymakers and operational people.
3. Candor in discussing negative developments.
C. Presentations to analyst groups: frequency and content
D. Company-sponsored field trips and meetings
E. Annual meetings
1. Accessibility.
2. Worthwhile to shareholders and analysts.27

Finally, the audit committee should be aware of the independent auditing
firm™s quality control policies and procedures, which provide reasonable assurance
that the firm has followed professional standards.28 The Auditing Standards Board
has issued the Statements on Quality Control Standards, which identifies five ele-
ments of quality control:

1. Independence, integrity, and objectivity
2. Personnel management
3. Acceptance and continuance of clients and engagements
4. Engagement performance
5. Monitoring

Such quality control standards provide a framework for the firm™s quality review
program. For example, member firms of the SEC Practice Section are required to
rotate engagement partners at least every seven years, and audit engagements are
subject to a second-partner review process. As noted in Chapter 2, Section 203 of
the Sarbanes-Oxley Act limits both the lead partner and concurring partners to a
maximum of five consecutive years of service with a five-year time-out.
In an article dealing with the subject of quality review by independent auditors,
Brian H. MacIver, James Welch, and Priscilla A. Burnaby report that three of the
previous nine quality control standards”namely, independence, supervision, and
consultation”are misunderstood or inadequately addressed. The authors note,
“The most common inadequacies cited by the team captain in review reports in-
cluded inadequate and deficient financial statement disclosures, inadequate check-
lists or failure to prepare checklists properly, and too many hours of continuing
professional education in the tax area rather than in the audit area.”29

27
Association for Investment Management and Research, Corporate Information Committee Report
1995“96 (Charlottesville, VA: AIMR, 1997), pp. 75“77. Also see Association for Investment Manage-
ment and Research, Financial Reporting in the 1990s and Beyond (Charlottesville, VA: AIMR,1993).
28
Statement on Auditing Standards No. 25, “The Relationship of Generally Accepted Auditing Stan-
dards to Quality Control Standards” (New York: AICPA, 1979). For further discussion, see Statement
on Quality Control Standards No. 2, “System of Quality Control for a CPA Firm™s Accounting and
Auditing Practice”; Statement on Quality Control Standards No. 3, “Monitoring a CPA Firm™s Ac-
counting and Auditing Practice”; AICPA Peer Review Board, Standards for Performing and Reporting
on Peer Reviews (New York: AICPA, 1996). The audit committee™s knowledge and understanding of
the independent accounting firm™s quality control policies and procedures is important to provide as-
surance to the full board of directors that the independent auditors are discharging their responsibili-
ties to the client company and the general public.
29
Brian H. MacIver, James Welch, and Priscilla A. Burnaby, “Quality Review”Observations of a
Team Captain,” Ohio CPA Journal 50, No. 1 (January“April 1991), pp. 54“55.
110 The External Users of Accounting Information


In their survey of 42 audit partners and managers, Ganesh Krishnamoorthy,
Arnie Wright, and Jeffrey Cohen concluded that:

[o]ne must go beyond just determining whether the committees comply with exist-
ing regulations. In fact, 81% of the respondents believe that you need to look at the
substance (the actual effectiveness of the audit committee) and not just the form of
audit committees. Thus, an audit committee might comply with all existing regula-
tions, but if they are not providing active oversight to the quality and integrity of the
financial reporting process, they cannot be relied upon.30
An example of the audit committee™s role and responsibilities in the financial
statement and disclosure matters of Wal-Mart Stores follows.

1. Review and discuss with management, and to the extent the audit Committee
deems necessary or appropriate, the Internal Auditors and the Outside Auditors,
the Company™s disclosure controls and procedures that are designed to ensure
that the reports the Company files with the Commission comply with the Com-
mission™s rules and forms.
2. Review and discuss with management, the Internal Auditors and the Outside Au-
ditor the annual audited financial statement, including disclosures made in man-
agement™s discussion and analysis, and recommended to the Board whether the
audited financial statements should be included in the Company™s Form 10-K.
3. Review and discuss with management, the Internal Auditors and the Outside Au-
ditor the Company™s quarterly financial statements, including disclosures made in
management™s discussion and analysis, prior to the filing of its Form 10-Q, in-
cluding the results of the Outside Auditor™s reviews of the quarterly financial
statements.
4. Review and discuss quarterly reports from the Outside Auditor on:
(a) All critical accounting policies and practices to be used;
(b) All alternative treatments within GAAP [generally accepted accounting prin-
ciples] for policies and practices related to material items that have been dis-
cussed with management, including ramifications of the use of such
alternative disclosures and treatments and the treatment preferred by the Out-
side Auditor;
(c) The internal controls adhered to by the Company, management, and the
Company™s financial, accounting and internal auditing personnel, and the
impact of each on the quality and reliability of the Company™s financial re-
porting; and
(d) Other material written communications between the Outside Auditor and
management, such as any management letter or schedule of unadjusted
differences.
5. Discuss in advance with management the Company™s practice with respect to the
types of information to be disclosed and the types of presentations to be made in
earnings press releases, including the use, if any, of “pro forma” or “adjusted”
non-GAAP information, as well as financial information and earnings guidance

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