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And, since inhouse legal counsel and outside counsel frequently interact with audit
committees, these lawyers are in an excellent position to help the committees develop a
constructive relationship between their function and the activities of the full board and, ul-
timately, minimize the potential for class-action suits by recognizing the warning signals
that lead to fraudulent reporting.c
For example, corporate legal counsel can assist the audit committees with the follow-
ing matters:
• Review and approve the standard of independence for the audit committee members
as required by the national stock exchanges and the SEC.
• Review the audit committee™s charter, which is disclosed in part in the company™s
annual proxy statement.
• Review significant litigation, claims and assessments with both in-house and out-
side legal counsel.
• Advise the committee with respect to any pending litigation against the external au-
ditors and any impairment of their independence.
• Advise the committee on proposed investigations and compliance with regulations.
Of course, outside legal counsel may be asked to serve on the audit committee, in
which case he or she would address the warning signals directly.
Given the audit committee™s critical role in the company™s internal control structure,
the committee must obtain reasonable assurances from the internal and external auditors
that management™s assertions in the financial statements are fairly presented. Moreover,
the external auditors are required by generally accepted auditing standards to communicate
certain matters to the audit committee.
In particular, the auditors are required to report material misstatements in the financial
statements or omissions of material information.
It should be emphasized that audit committees should be highly attuned to potential
situations of fraudulent financial reporting.
Failure on the part of an audit committee to question management™s representations
may be the basis for audit committee malfeasance, since the audit committee and the board
may be held liable for their failure to know what they were responsible for recognizing.

Source: This discussion is adapted from an article by Louis Braiotta, Jr., “Auditing for Honesty,”
American Bar Association Journal 78, No. 5 (May 1992), pp. 76“79. Copyright (c) 1992 by Louis
Braiotta, Jr.
a
More recently, the SEC has filed actions against the officers and directors and accounting firms,
respectively: 1993 (36, 17); 1994 (78, 31); 1995 (71, 11); 1996 (59, 20); 1997 (90, 22), 1998 (64,
15); 1999 (81, 13); 2000 (78, 25); 2001 (92, 20); 2002 (138, 25). For additional reading, see a Best
Practices Council of the National Association of Corporate Directors report entitled, Coping with
Fraud and Other Illegal Activity (Washington, DC: National Association of Corporate Directors,
1998); Committee of Sponsoring Organizations of the Treadway Commission, Fraudulent Financial
Reporting: 1987“1997 An Analysis of U.S. Public Companies (New York: Committee of Sponsoring
Organizations of the Treadway Commission, 1999). See the SEC Annual Reports for further
information on enforcement proceedings and related cases and Exhibit 4.3.
b
For further reading, see Curtis C. Verschoor, “A Case Study of Audit Committee Effectiveness at
Sundstrand,” Internal Auditing 4, No. 4 (Spring 1989), pp. 11“19. Also see Verschoor™s article,
“Miniscribe: A New Example of Audit Committee Ineffectiveness,” Internal Auditing 5, No. 4
(Spring 1990), pp. 13“19.
c
See Exhibit 4.2 for further details.
164




Exhibit 4.2 Warning Signals of the Possible Existence of Fraudulent Financial Reporting

Symptom Problem Solution
I. Industry Matters
Competitive and economic conditions Overoptimistic news releases with respect Analyze annual and interim earnings trends to avoid
to earnings. increased opportunities for managing earnings.
Capital investment in a rapidly
changing industry.
Competitive foreign businesses Foreign competitors have significant Discuss management™s strategy as it relates to financial
advantages. matters.
Government regulations The industry is subject to new regulations Obtain assurance on the entity™s compliance affecting
that increase the cost of compliance. financial matters.
Industry accounting practices Unusual revenue recognition policies and/or Access significant accounting policies that are industry-
deferred expenses to increase earnings. specific from the NAARS data base, and review and
discuss this information with the independent auditors.

II. Entity™s Business Matters
Organizational structure High turnover in key accounting personnel Determine the reasons for such personnel turnover.
(e.g., controller). Complex corporate
structure that is not warranted.
Lines of business and product segments Rapid expansion of business lines in excess Investigate the reasons for this rapid expansion.
of industry averages.
Lack of security over computer operations Control procedures over computer are weak. Inquire of management key security problems.
The Legal Position of the Audit Committee
Accounting policies Significant changes in accounting practices Compare the entity™s policies with the industry norms and
and estimates by management with an determine the reasons for the changes. Raise questions
excessive interest in earnings. Unusual on issues that support these transactions; determine the
year-end transactions that increase earnings. reasons for the inconsistent disclosures.
Inconsistencies between financial statements,
MDA, and the president™s letter.
Conflict-of-interest Significant contracts that affect financial Determine management intent to disclose such contracts;
statements. Frequent related-party transactions. determine how the company addresses possible conflict-
Failure to enforce the corporate code of of-interest situations; determine how management
conduct. monitors compliance with the code.
Frequent change of legal counsel Disagreements on asserted or unasserted Discuss disclosures with general counsel and outside
claims and contingencies. counsel.
Unexplained significant fluctuations in Material physical inventory variances. Focus on the analytical review procedures.
account balances

III. External Auditing Matters
Legal Cases Involving the Audit Committee




Frequent change of auditors Disagreement on GAAP, which causes Investigate the reasons for frequent changes in auditors.
opinion shopping.
Quantity of lawsuits against the CPA firm Firm has violated the securities laws. Review the latest peer review report and the number of
lawsuits against the firm.
Nonacceptance of recommendations in Breakdowns in the internal control structures. Obtain assurance from the auditors that management has
the management letter evaluated the weaknesses and that corrective action has
been taken.

IV. Internal Auditing Matters
Departmental organization The size of the internal audit department is Discuss this matter with chief internal auditor and
not compatible with the size of the company. independent auditor.
Reporting responsibility Scope restrictions. Direct access to the audit committee.
165
166 The Legal Position of the Audit Committee



Exhibit 4.3 Unethical Practices in Financial Reporting

SEC Enforcement Divisiona
Summary of Selected Cases and Alleged Violations”Financial Disclosures
Fiscal Year ended 1989“1997
Date Release
Filed No. Nature of Alleged Violations

11/1/88 AAER”208 SEC alleged improper accounting practices (e.g., holding
quarterly financial records open to record additional sales;
preparing invoices for orders that had not been shipped;
and delaying the issuance of credit memos for orders that
had been returned). The company and seven officers and
employees consented to the entry of the Commission™s
orders against them.
1/9/89 AAER”212 The registrant had overstated earnings and inventory by
inflating quantity and cost figures on inventory count
sheets and arranged for the supplier to send a false
confirmation to the auditors. The company, its officers, its
supplier, and the supplier™s president all consented to entry
of permanent injunctions.
2/8/89 AAER”215 SEC alleged the improper recognition of revenue. The
alleged scheme involved failure to record at least $13 mil-
lion of product returns and the recording of more than $5
million of fictitious revenue from false invoices. Two de-
fendants consented to the entry of injunctions against them.
6/6/89 LR”12119 The company had overstated revenues by prematurely
recording a total of 20 transactions as sales even though the
sales have not been completed.
9/6/89 AAER”247 SEC filed an action against officers, directors, and
employees. Commission alleged the company falsified
financial records to overstate pretax income of $20.6
million instead of a loss in 1987. Defendants sold over $60
million of stock that did not reflect the value of the
company. Three defendants consented to the entry of
injunctions against them.
5/24/90 AAER”258 The registrant recorded unsupported adjustments to
revenue. The Commission alleged the company filed
materially false and misleading financial statements.
10/11/90 AAER”279 SEC alleged that former officers engaged in improper
revenue recognition practices. They are: (1) recorded
transactions as sales when customers had not agreed to
purchase the equipment and the equipment was not
delivered; (2) recorded trials as sales transactions; and (3)
removing inventory to simulate delivery of goods sold. The
defendants consented to the entry of injunctions.
10/26/90 AAER”282 The CEO directed officers and employees to engage in a
scheme to inflate accounts receivable and inventory. The
perpetration created phony invoices to generate sales. Also,
the CEO and two other defendants sold common stock
when they knew that the market price was based on
Legal Cases Involving the Audit Committee 167



Date Release
Filed No. Nature of Alleged Violations

materially false representations. Two of the defendants
consented to the entry of injunctions.
8/20/91 AAER”311 The corporation used improper revenue recognition
practices by recording sales at the time a purchaser agreed
verbally to purchase equipment. Also, the client misled the
auditors by falsely indicating that certain tractors were
loaded for shipment and that risk of loss had passed to the
purchaser. The company and two of the individual
defendants consented to the entry of injunction.
3/31/92 AAER”363 SEC alleged that the company failed to disclose the
importance of its subsidiary™s 1989 earnings in the MD&A
section of the Form 10-K. The subsidiary accounted for
about 23 percent of the parent company™s net profit of $497
million. Much of the gain resulted from the country™s
hyperinflation and a favorable exchange rate. The parent
company consented to a cease and desist order.
9/30/93 LR”13813 The Commission alleged that the company made misrepre-
sentations and omissions regarding the deterioration in
sales of software and the shipment of $5.2 million of
products to certain customers as conditional or fictitious
sales. Individual defendants consented to the entry of
orders requiring them to disgorge over $2 million and one
consented to the entry of a bar from acting as an officer or
director of a publicly held company.
3/29/94 EAR”33829 The Commission alleged that, as a result of a fraudulent
accounting scheme implemented by three members of the
company™s senior management, the company reported mate-
rially overstated sales, net income, and assets in periodic
filings between 1989 and 1992. The inflated sales and earn-
ings enabled the company to falsely report continued growth
in revenue and earnings when the company was not profit-
able. Overall, the company reported nearly $38 million in
sales between 1989“1992 that had not taken place.
1/4/95 LR”14375 The company improperly recognized revenue on several
transactions. The company™s false claims of having sold
simulators to customers resulted in income statements in
which total revenue was inflated by 46 percent to 93
percent.
9/19/96 R”34-37701 The company filed a 10Q that contained financial
statements which materially overstated revenue and
materially understated losses by improperly recognizing
revenue from purported bill and hold transactions.
2/18/97 LR”15260 The company materially overstated earnings and
profitability prior to a convertible debt offering. The
company consented to entry of an injunction and an order
requiring the payment of $3.28 million in disgorgement.
8/5/98 LR-15832 The registrant consented to the issuing of a cease-and-
desist order in which the SEC found that the company


(continued)
168 The Legal Position of the Audit Committee



Exhibit 4.3 (Continued)

Date Release
Filed No. Nature of Alleged Violations

violated the periodic reporting provisions. The SEC found
that during the four months preceding the company™s
writedown of $2.7 billion of goodwill, the company made
inadequate disclosures about the nature and extent of its
net losses.
1/13/99 AAER-1095 The SEC alleged that the registrant made at least 17 false
filings in which the company materially overstated its
results of operations and financial condition. Four of the
defendants consented to the entry of injunction.
10/28/99 LR-16344 The SEC alleged that the defendants engaged in a
fraudulent scheme to recognize millions of dollars of
revenue prematurely by improperly recording purported
“bill and hold” sales to meet sales projections.
9/28/00 EAR-43372 The SEC settled civil administrative fraud charges against
a foreign issues for issuing materially false denials
concerning merger negotiations. The registrant consented
to an entry of a cease and desist order.
5/15/01 LR-17001 The Commission alleged that the defendants engaged in a
scheme to fraudulently misrepresent the company™s results
of operations through the creation of inappropriate
accounting reserves””cookie jar reserves.” The scheme
was used to purport a rapid turnaround. As a result, at least
$60 million of the company™s reported earnings came from
the accounting fraud.
9/12/01 LR-17126 The SEC instituted a settled administrative proceeding
against the registrant for books and records violations
associated with illegal payments to foreign officials. The
$75,000 illegal payment was made in violation of the
Foreign Corrupt Practices Act. This was the first joint
action that the SEC and the Department of Justice filed
under the Act.
8/21/02 AAER-1617 The SEC filed and settled a civil action against a former
officer alleging that he used complex structures, strawmen,
hidden payments, and secret loans to create the appearance

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