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independent check on corporate management with respect to its responsibilities
for reporting its stewardship accountability to the outside constituencies. In par-
ticular, the audit committee is responsible for assuring that management has pre-
pared the financial statements in conformity with generally accepted accounting
principles (GAAP). Thus it must assess not only management™s judgment regard-
ing the application of accounting principles but also the adequacy of the disclo-
sures in the financial statements.1 According to the American Institute of Certified
Public Accountants, the committee™s review objective may be summarized in this
way:



1
For a more detailed discussion of accounting principles, see Chapter 5.


291
292 Reviewing Accounting Policy Disclosures


The audit committee should meet with management and the external auditor to re-
view the financial statements and the audit results. This is an especially important
function of the audit committee.
Some audit committees confine their review of the financial statements to major or
critical items, while others examine the statements in considerable detail. The scope
of the review is something each audit committee must set forth for itself, bearing in
mind that at the conclusion of the meeting the members should have a comprehen-
sive understanding of any major financial reporting problems encountered, how they
were resolved, and whether the resolution is satisfactory. Factors affecting the extent
of the review include the committee™s confidence in management, the system of in-
ternal accounting control, and the external auditor; the existence of any unresolved
differences between the auditor and management; the extent of adjustments or addi-
tional disclosures, if any, proposed by the auditor; and any unusual occurrences dur-
ing the year. The committee™s major concern throughout the review should be
whether the financial statements fairly present the company™s financial results in con-
formity with generally accepted accounting principles.2

In addition, it is important that audit committee members be aware that the
Public Oversight Board has issued these recommendations with respect to deter-
mination of accounting treatment in the financial reporting process:

Recommendation V-6
The following recommendation of the Macdonald Commission should be adopted by
the Auditing Standards Board in the United States:
When new accounting policies are adopted in response to new types of transac-
tions or new kinds of assets or obligations, the auditor should be satisfied that the
accounting policies adopted properly reflect the economic substance of the trans-
action, asset, or liability in accordance with the broad theory governing present-
day financial reporting and the established concept of conservatism in the face of
uncertainty.
Recommendation V-7
Peer reviewers should evaluate the consultation process by which specific account-
ing conclusions are reached, as they do now, and should also inquire whether that
process leads to accounting that is appropriate in the circumstances. In testing com-
pliance with the consultation policies and procedures in a firm, the peer review team
should evaluate the quality of the conclusions reached.
Recommendation V-8
The concurring partner, whose participation in an audit is a membership requirement
of the SEC Practice Section, should be responsible for assuring that those consulted
on accounting matters are aware of all of the relevant facts and circumstances, in-
cluding an understanding of the financial statements in whose context the account-
ing policy is being considered. The concurring and consulting partners should know
enough about the client to ensure that all of the relevant facts and circumstances are
marshalled, and also possess the increased detachment that comes from not having


2
American Institute of Certified Public Accountants, Audit Committees, Answers to Typical Questions
About Their Organization and Operations (New York: AICPA, 1978), pp. 16“17.
Audit Committee™s Review Objective 293


to face the client on an ongoing basis. The concurring partner should have the re-
sponsibility to conclude whether the accounting treatment applied is consistent with
the objectives of Recommendation V-6.3

The American Institute of Certified Public Accountants has set forth the fol-
lowing to further ensure the independent auditor™s integrity and objectivity in the
financial reporting process:

The credibility of the independent audit is essential to public trust, the keystone of
the financial reporting system. The accounting profession prides itself on the in-
tegrity and objectivity of its members. The future of our profession, not to mention
our livelihood, rests on this reputation.
A few recent high-profile financial scandals have, however, called auditors™ inde-
pendence into question. Neither the accounting profession nor the financial markets
can afford an erosion of public confidence. For that reason, auditors must scrupu-
lously preserve their objectivity, in reality and appearance. We therefore call on the
SEC and other regulatory bodies to prohibit public companies and other organiza-
tions with public accountability from hiring the partner responsible for their audit for
one year after the partner ceases to serve that client.
Additional steps can be taken, with the support of the business community, to secure
public confidence in the independent audit and the financial reporting system. SEC
registrants and other publicly accountable organizations should be required to have
audit committees composed entirely of independent directors whenever practicable.
The audit committee members should be charged with specific responsibilities, in-
cluding overseeing the financial reporting process, and recommending appointment
of the entity™s auditors.4

The reader may wish to revisit Chapter 1 and Chapter 3 to review the key dis-
cussion points made by several key organizations about the financial reporting
process. While the preceding review objective is broad based, it is important to
reemphasize the audit committee™s position regarding such review activities. As
John J. Schornack, former partner of Arthur Young & Co. (now Ernst & Young),
points out:

Audit committee members are not omniscient. . . . Matters of compliance with pro-
fessional reporting standards and technical disclosures are the responsibilities of
corporate management and the professional experts such as the outside auditor and
legal counsel. . . . The primary purpose of the audit committee is oversight of the fi-
nancial reporting.5

James Gerson et al., partners of Coopers & Lybrand (now PricewaterhouseCoop-
ers), note that “to effectively review financial statements, the audit committee

3
Public Oversight Board, A Special Report by the Public Oversight Board of the SEC Practice Sec-
tion, AICPA (Stamford, CT: POB, 1993), pp. 48“49.
4
American Institute of Certified Public Accountants, Meeting the Financial Reporting Needs of the
Future: A Public Commitment from the Public Accounting Profession (New York: AICPA, 1993), p. 4.
5
John J. Schornack, “The Audit Committee”A Public Accountant™s View,” Journal of Accountancy
147, No. 4 (April 1979), p. 74.
294 Reviewing Accounting Policy Disclosures


must understand the company™s business and industry, and the attendant risks.
The committee should be satisfied that the key financial systems and the proce-
dures and controls that support them will generate information necessary to man-
age and properly report on the operations of the company.”6 The authors further
state:

Typically, the committee meets with management and the independent auditors to re-
view the financial statements for the year and the results of the annual audit. The na-
ture of this review depends on the complexity of the company, its industry, and the
committee™s confidence in company management. When performing this review, the
committee should pay particular attention to judgmental areas, such as those involv-
ing valuation of assets and liabilities. The committee should be sensitive to areas
where different assumptions and judgments could have a significant effect on the
statements. These areas could include accounting and disclosure for obsolete or
slow-moving inventory; the allowance for doubtful accounts; warranty, product lia-
bility and litigation reserves; and commitments and contingencies.7

In January 2003, the Securities and Exchange Commission issued rules that re-
quire independent auditors to report on a timely basis certain information to the
audit committee. These rules are pursuant to Section 204, Auditor Reports to Audit
Committees, under the Sarbanes-Oxley Act of 2002, which state:

In particular, the Sarbanes-Oxley Act requires that the auditor report to the audit
committee on a timely basis (a) all critical accounting policies used by the registrant,
(b) alternative accounting treatments that have been discussed with management
along with the potential ramifications of using those alternatives, and (c) other writ-
ten communications provided by the auditor to management, including a schedule of
unadjusted audit differences. These rules strengthen the relationship between the
audit committee and the auditor.8

These rules are presented in the next section of this chapter.
Such oversight responsibility of the audit committee is evidenced in Wal-
Mart™s annual report, as presented in Exhibit 10.1.
Thus, in order to discharge its oversight responsibility concerning financial re-
porting, the committee™s agenda should include a review of the significant ac-
counting policies and their related disclosure requirements as well as critical

6
James S. Gerson, J. Robert Mooney, Donald F. Moran, and Robert K. Waters, “Oversight of the Fi-
nancial Reporting Process”Part I,” CPA Journal 59, No. 7 (July 1989), p. 28.
7
James S. Gerson, J. Robert Mooney, Donald F. Moran, and Robert K. Waters, “Oversight of the Fi-
nancial Reporting Process”Part II,” CPA Journal 59, No. 8 (August 1989), p. 40. A study on the as-
sociation between audit committee formation and the quality of accounting earnings found “a significant
increase in the market™s reaction to earnings reports subsequent to the formation of the audit committee”
(p. 1). See John J. Wild, “The Audit Committee and Earnings Quality,” Journal of Accounting, Auditing
& Finance 11, No. 2 (Spring 1996), pp. 247“276. Also, the reader should visit the AICPA™s SEC Practice
Section web site at www.aicpa.org/members/div/secps/index.htm for the Practice Alert 2000-2, “Quality
of Accounting Principles-Guidance for Discussions with Audit Committees.”
8
Securities and Exchange Commission, Release No. 33-8183, “Strengthening the Commission™s Re-
quirements Regarding Auditor Independence,” January 28, 2003, www.sec.gov/rules/final/33-
8183.htm, p. 3.
Audit Committee™s Review Objective 295



Exhibit 10.1 Illustrative Management Report

Report of Management
Management of Wal-Mart Stores Inc. is responsible for the integrity and objectivity of the
financial statements and other information presented in this report. These financial state-
ments have been prepared in conformity with accounting principles generally accepted in
the United States. The preparation of financial statements requires certain estimates and
judgments, which are based upon currently available information and management™s view
of current conditions and circumstances.
Management has developed and maintains a system of internal and disclosure controls, in-
cluding an extensive internal audit program. These controls are designed to provide rea-
sonable assurance that the Company™s assets are protected from improper use and that
Wal-Mart™s accounting records provide a reliable basis for the preparation of financial
statements. We continually review, improve and modify these systems and programs in re-
sponse to changes in business conditions and operations and the recommendations made
by Wal-Mart™s internal and external auditors. We believe that the system of internal and
disclosure controls provides reasonable assurance that Wal-Mart™s assets are safeguarded
and that the financial information disclosed is reliable.
Our Company was founded on the belief that open communications and the highest standard
of ethics are necessary to be successful. Our long-standing “open door” communication pol-
icy helps management be aware of and deal with issues in a timely and effective manner.
Through the open door policy all Associates are encouraged to inform management at the ap-
propriate level when they are concerned about any matter pertaining to the Company.
Wal-Mart has adopted a Statement of Ethics to guide our Associates in the continued ob-
servance of high ethical standards such as honesty, integrity and compliance with the law
in the conduct of the Company™s business. Familiarity and compliance with the Statement
of Ethics is periodically reviewed and acknowledged in writing by all management Asso-
ciates. The Company also has in place a Related Party Transaction Policy. This policy ap-
plies to all Officers and Directors of the Company and requires material related party
transactions to be reviewed by the Audit Committee of the Board of Directors. Annually,
the Company™s Officers and Directors report material related party transactions to the
Company and Officers acknowledge their familiarity and compliance with the policy.
We retain Ernst & Young LLP, independent auditors, to audit the Company™s financial state-
ments. Their audits are performed in accordance with generally accepted auditing standards.
We have made available to Ernst & Young LLP all financial records and related data.
The Board of Directors, through the activities of its Audit Committee consisting solely of out-
side directors, provides oversight of the process of reporting financial information. The Com-
mittee stays informed of the financial condition of the Company and regularly reviews its
financial policies and procedures, the independence of the Company™s independent auditors,
its internal accounting controls and the objectivity of its financial reporting. Both the Com-
pany™s independent auditors and the internal auditors have free access to the Audit Commit-
tee and meet with the Committee periodically, both with and without management present.


H. Lee Scott Thomas M. Schoewe
President and Chief Executive Executive Vice President and Chief
Officer Financial Officer


Source: Wal-Mart Stores, Inc., 2003 Annual Report, p. 52.
296 Reviewing Accounting Policy Disclosures


accounting policies. Such a review will enable the committee to obtain assurance
that management is fulfilling its financial accounting and reporting responsibilities.
Furthermore, since the board of directors is concerned primarily with corporate
policies, the committee can ensure that major changes in accounting policies are
brought before the board in a timely manner. Therefore, the remainder of this chap-
ter will discuss the committee™s role in reviewing accounting policy disclosures.9


ACCOUNTING POLICY DISCLOSURES
Accounting Policies
As noted in Chapter 4, the Securities and Exchange Commission in the Killearn
Properties case indicated that the audit committee should have at least general fa-
miliarity with accounting and reporting principles and practices in preparing its fi-
nancial statements. Thus the committee members should have a broad overview of
the significant accounting policies. Such a task is a critical undertaking since it re-
quires the committee to judge management™s formulation and implementation of
such policies. The committee will look to the independent public accountants™ pro-
fessional assessment of the entity™s accounting policies in accordance with the dis-
closure requirements, discussed in Chapter 5. For example, the audit committee™s
understanding of the information in the financial statement and significant ac-
counting policies is evidenced by the data included in the Report of Management,
as illustrated by Wal-Mart Stores, Inc., in Exhibit 10.1.
The independent auditors must be satisfied that management is complying
with the disclosure requirements as outlined by the Accounting Principles Board.10
For example, management must present a summary of the significant accounting
policies as part of the financial statements in the annual report. Such disclosure of
significant accounting policies sets forth the accounting principles and methods
used to prepare the financial statements. A summary of significant accounting
policies frequently includes:11

• Basis of consolidation and use of estimates and assumptions
• Depreciation methods
• Financial instruments

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