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disagreement with the auditors.
F. Have we reviewed the lawyer™s letter concerning litigations, claims, and
174 The Legal Position of the Audit Committee

1. The lawyer™s letter contains the opinion of legal counsel with respect
to potential litigation, such as a pending lawsuit. Such information is
provided to the CPA firms for possible disclosure in the financial
2. Discuss the accounting treatment concerning the contingency losses
and effect on the financial statements.
G. Have we reviewed the letter of management™s representation?
The chief financial officer and chief executive officer will furnish a letter
to the auditing firm with respect to the corporation™s representations
concerning the financial position and the results of operations. This
letter should be examined in view of the facts in the letter and in the
financial statements. This letter is particularly important since it con-
firms management™s responsibilities for the financial statements.
H. Have we reviewed:
1. Any amendments to the bylaws or corporate charter?
2. The minutes of the meetings of the board of directors, directors™
committees, and stockholders (e.g., compensation committee or fi-
nance committees)?
I. Have we reviewed the corporation™s compliance with the auditors and
legal counsel concerning the:
1. Securities statutes?
2. Antitrust laws?
3. Income tax laws?
4. Labor laws?
5. Regulatory laws applicable to the industry?
J. Have we made an evaluation of any material non“arm™s-length transac-
tions, such as loans to officers?
K. Have we reviewed:
1. Results of peer review?
2. Litigation against the CPA firm?
3. Adequacy of professional liability insurance?
4. Independence issues as required by ISB Standard No. 1?
5. Required disclosures to the audit committee as required by SAS #61?
6. Extent of management services provided by CPA firm and impact on
II. The Internal Auditors47
A. Have we reviewed the qualifications of the internal audit staff?
1. Review the backgrounds of the director of internal auditing and the
internal auditing group.
2. Inquire about the internal audit staff™s participation in the programs
of the Institute of Internal Auditors and other professional societies.
3. Discuss their qualifications with the independent auditing firm.
B. Have we reviewed their charter or audit plan?

For further reference, see Exhibit 9.11 in Chapter 9, “Vital Checkpoints: Internal Audit Questions
for the Audit Committee,” prepared by Richard Hickok and Jules Zimmerman.
Guidelines for Minimizing Legal Liability 175

C. Have we considered the reporting responsibility of the internal audit
D. Is there evidence that the work of the internal audit staff was properly
planned, supervised, and reviewed?
See item number C under “The Independent Auditors.”
E. Have we reviewed:
1. Reports on compliance audits?
2. Reports on operational audits?
3. Reports on financial audits?
4. Reports on the system of internal accounting and administrative
• Have we reviewed the recommendations made in their reports with
respect to objectivity?
• Have we considered the possibility of a long-form report from the
Director of Internal Auditing?
F. Have the internal auditors™ recommendations in connection with the
prior years™ internal audit been implemented?
G. Have we scrutinized cases of management disagreements with the inter-
nal auditors?
H. Have we reexamined the relationship of the internal audit function to the
other departments?
I. How are activities of the internal audit staff and the independent auditors
J. If the corporation has an electronic data processing installation, have
we considered the use of independent EDP consultants to audit the

III. The Representatives of Management (Chief Executive Officer, Chief Finan-
cial Officer, Treasurer, and Controller)
A. Are the qualifications of the representatives of management consistent
with the corporate bylaws?
B. Have we reviewed their administrative functions in relationship to the pre-
sent financial and accounting policies? (See company™s organization
C. Have these individuals exercised their authority in accordance with the
corporate bylaws?
D. Have we reviewed the minutes of the meeting of the board of directors
concerning their compensation?
E. Have we reviewed their written reports concerning their responses to the
deficiencies noted in the internal audit reports?
F. Are all employees who handle cash, securities, and other valuables bonded?
G. Are the financial and accounting policies and procedures set forth in
H. Are interim financial reports prepared for submission to management on
a timely basis?
176 The Legal Position of the Audit Committee

I. Is the quality and quantity of information in the interim reports adequate?
J. Have we discussed cases of management disagreements with the auditors?
K. Have we discussed:
1. The engagement letter?
2. The management letter from the independent auditors?
3. The letter of management™s representations?
4. The lawyer™s letter?
L. Have we discussed the periodic filings with the various regulatory agencies?

Signed by: ____________________________________ Date ____________
[Should be signed by the chairman of the audit committee]48

In view of the preceding discussions on the legal position of the audit com-
mittee, it is important that the audit directors fully understand the nature and scope
of their legal responsibilities concerning the corporation™s outside constituencies
and the securities markets. However, they should keep their legal obligations in
proper perspective. Such obligations should be integrated and balanced with the
committee™s functions so that the committee™s purpose is not defeated. In short, the
directors should discharge their responsibilities in a professional manner and not
become totally preoccupied with the legal rules and regulations.

American Bar Association, Corporate Director™s Guidebook (Chicago: ABA, 1978).
American Bar Association, Corporate Director™s Guidebook (Chicago: ABA, 1994).
American Bar Association, Report of The American Bar Association Task Force on Corpo-
rate Responsibility (Chicago, ILL: American Bar Association, 2003), pp. 1“89.
Bomark, Inc. v. Hemodynamics, Inc., 848 F. Supp. 1335 (W.D.M.I. 1993).
Braiotta, Louis, “Auditing for Honesty.” American Bar Association Journal, 78, No. 5 (May
1992), pp. 76“79.
Commerce Clearing House, Federal Securities Law Reporter (Chicago: Commerce Clear-
ing House, 1972“73, 1974“75, 1977“78 Transfer binder).
Commerce Clearing House, Federal Securities Law Reporter (Chicago: Commerce Clear-
ing House, 1984“1985 Transfer binder).
Committee on Corporate Laws, Section of Corporation, Banking and Business Law of the
American Bar Association, Revised Model Business Corporation Act”Chapter 8: Direc-
tors and Officers (Chicago, Ill.: American Bar Association, 1984).
Committee on Corporate Laws of the Section of Business Law, Model Business Corpora-
tion Act”Chapter 8: Directors and Officers (Chicago, Ill.: American Bar Association, 1998).

It is advisable that the audit committee document its activities and have in-house counsel or outside
legal counsel review documentation for content and use prior to adoption. Such procedures will help
protect the audit committee in cases of possible litigation.
Sources and Suggested Readings 177

Connecticut General Statutes Annotated, Sections 33-318(b)(1) and (2), West 1960 and
Supplement 1985.
“Firing Line,” Time (February 19, 1979), p. 51.
Guttman v. Jen-Hsun Huang et al. Nvidia Corporation, C.A. No. 19571-N.C. (Del. Ch.
Internal Revenue Code Chapter 75A, Crimes (1954).
Haltman, et al. v. Aura Systems, Inc., et al., 844 F. Supp. 544 (C.D.C.A. 1993).
In re Caremark, Derivative Litigation Delaware Court of Chancery, 1996 698 A. 2d 959.
In re Livent, Inc. Securities Litigation, 148 F. Supp. 2d 331 (S.D.N.Y. 2001).
International, Inc. Derivative Litigation, 698 A. 2d 959 (Del. Ch. 1996).
Manzo v. Rite Aid Corporation, C.A. No. 18451-N.C. (Del. Ch. 2002).
Lancaster, Hal, “Fuss at Cal Life Shows Audit Committee Role is Crucial, Experts Say.”
The Wall Street Journal (March 17, 1980). p. 1.
Marsh, Hugh L., and Thomas E. Powell, “The Audit Committee Charter: Rx for Fraud Pre-
vention.” Journal of Accountancy, 167, No. 2 (February 1989), pp. 55“57.
New York Business Corporation Law, McKinney™s Consolidated Laws of New York Anno-
tated (Brooklyn, N.Y.: Edward Thompson Company, 1963, Book 6).
Petziner, Thomas, Jr., “Heinz Senior Officials Didn™t Participate in Profit-Juggling Prac-
tices, Panel Says.” The Wall Street Journal (May 9, 1980), p. 2.
Powers, William C., Report of Investigation by the Special Investigative Committee of the
Board of Directors of Enron Corporation (February 1, 2002), http://news.findlaw.com/
Sarbanes-Oxley Act of 2002, Section 307, Rules of Professional Responsibility for Attor-
neys, H.R. Rep. No. 107-610 (2002).
Securities and Exchange Commission, 1993, 1994, 1995, 1996, 1997 Annual Reports
(Washington, DC: U.S. Government Printing Office).
Securities and Exchange Commission, Release No. 33-8155, Implementation of Standards
of Professional Conduct for Attorneys (January 29, 2003).
Securities Exchange Act Rule 10(b)-5, Title 17, Code of Federal Regulations, Sec. 240
Securities and Exchange Commission, The Work of the Securities and Exchange Commis-
sion (Washington, DC: U.S. Government Printing Office, 1974).
United States Code, Titles 15 and 18 (1970).
Verschoor, Curtis C., “Miniscribe: A New Example of Audit Committee Ineffectiveness.”
Internal Auditing 5, No. 4 (Spring 1990), pp. 13“19.
Verschoor, Curtis C., “A Case Study of Audit Committee Effectiveness at Sundstrand,” In-
ternal Auditing 4, No. 4 (Spring 1989), pp. 11“19.
The Wall Street Journal Staff Reporter, “Playboy Audit Committee Bares Details of
Hefner™s High Living on Firm™s Tab.” The Wall Street Journal (April 4, 1980), p. 6.
Chapter 5
Rules of the Road”
Auditing and Related
Accounting Standards

The purpose of this chapter is to introduce the broad framework of generally ac-
cepted auditing standards and the integration of such standards with their respec-
tive generally accepted financial accounting standards. The integration of auditing
and accounting standards will enhance the audit committee™s understanding of the
application of accounting standards in the preparation of the financial statements.
Moreover, the audit committee will acquire not only a broad perspective on the es-
sential purpose of the audit examination, but also the salient points concerning the
auditors™ report. In succeeding chapters, additional financial accounting standards
will be discussed in more detail.

Nature of Generally Accepted Auditing Standards
In Chapter 2, reference was made to the auditing standards concerning the scope
paragraph of the auditors™ report. More specifically, the auditors state:

We conducted our audit in accordance with auditing standards generally accepted in
the United States of America. Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also in-
cludes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation. We
believe that our audit provides a reasonable basis for our opinion.

Explicit in the preceding sentence is the auditors™ representation that the audit ex-
amination has been conducted based not only on authoritative guidelines or rules
as established by the American Institute of Certified Public Accountants but also
on their professional judgment in the application of auditing procedures. As ap-
proved and adopted by the membership of the AICPA, generally accepted auditing
standards are as follows:

An Overview of Generally Accepted Auditing Standards 179

General Standards
1. The audit is to be performed by a person or persons having adequate technical
training and proficiency as an auditor.
2. In all matters relating to the assignment, an independence in mental attitude is to
be maintained by the auditor or auditors.
3. Due professional care is to be exercised in the performance of the audit and the
preparation of the report.

Standards of Field Work
1. The work is to be adequately planned and assistants, if any, are to be properly
2. A sufficient understanding of the internal control structure is to be obtained
to plan the audit and to determine the nature, timing, and extent of tests to be
3. Sufficient competent evidential matter is to be obtained through inspection, ob-
servation, inquiries, and confirmations to afford a reasonable basis for an opinion
regarding the financial statements under audit.

Standards of Reporting
1. The report shall state whether the financial statements are presented in accor-
dance with generally accepted accounting principles.
2. The report shall identify those circumstances in which such principles have not
been consistently observed in the current period in relation to the preceding
3. Informative disclosures in the financial statements are to be regarded as reason-
ably adequate unless otherwise stated in the report.
4. The report shall either contain an expression of opinion regarding the financial
statements taken as a whole or an assertion to the effect that an opinion cannot be
expressed. When an overall opinion cannot be expressed, the reasons therefore
should be stated. In all cases where an auditor™s name is associated with financial
statements, the report should contain a clear-cut indication of the character of the
auditor™s work, if any, and the degree of responsibility the auditor is taking.1

These auditing standards provide a useful framework for measuring the qual-
ity of the auditors™ professional performance concerning the audit examination and
the audit report. Such standards are totally inflexible because the public accoun-
tancy profession wishes to maintain high standards and uniformity in the practice


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