<<

. 7
( 82 .)



>>

quirements of Rule 10A-3(b)(1) under the Exchange Act, subject to the exemptions
provided for in Rule 10A-3(c).
Commentary Applicable to All Companies: While it is not the audit committee™s
responsibility to certify the company™s financial statements or to guarantee the audi-
tor™s report, the committee stands at the crucial intersection of management, inde-
pendent auditors, internal auditors and the board of directors. The Exchange supports
additional directors™ fees to compensate audit committee members for the significant
time and effort they expend to fulfill their duties as audit committee members, but
does not believe that any member of the audit committee should receive any com-
pensation other than such director™s fees from the company. If a director satisfies the
definition of “independent director” set out in Section 303A(2), then his or her re-
ceipt of a pension or other form of deferred compensation from the company for
prior service (provided such compensation is not contingent in any way on contin-
ued service) will not preclude him or her from satisfying the requirement that direc-
tor™s fees are the only form of compensation he or she receives from the company.
An audit committee member may receive his or her fee in cash and/or company stock
or options or other in-kind consideration ordinarily available to directors, as well as
all of the regular benefits that other directors receive. Because of the significantly
greater commitment of audit committee members, they may receive reasonable com-
pensation greater than that paid to the other directors (as may other directors for
other committee work). Disallowed compensation for an audit committee member
includes fees paid directly or indirectly for services as a consultant or a legal or fi-
nancial advisor, regardless of the amount. Disallowed compensation also includes
compensation paid to such a director™s firm for such consulting or advisory services
even if the director is not the actual service provider. Disallowed compensation is not
intended to include ordinary compensation paid in another customer or supplier or
business relationship that the board has already determined to be immaterial for pur-
poses of its basic director independence analysis. To avoid any confusion, note that
this requirement pertains only to audit committee qualification and not to the inde-
pendence determinations that the board must make for other directors.
Commentary Applicable to All Companies Other than Foreign Private Issuers: Each
member of the committee must be financially literate, as such qualification is inter-
preted by the company™s board in its business judgment, or must become financially
literate within a reasonable period of time after his or her appointment to the audit

19
The Business Roundtable, Principles of Corporate Governance (Washington, DC: The Business
Roundtable, May 2002), pp. 12“16.
26 Corporate Accountability: The New Environment


committee. In addition, at least one member of the audit committee must have ac-
counting or related financial management expertise, as the company™s board inter-
prets such qualification in its business judgment. A board may presume that a person
who satisfies the definition of audit committee financial expert set out in Item 401(e)
of Regulation S-K has accounting or related financial management expertise.
Because of the audit committee™s demanding role and responsibilities, and the time
commitment attendant to committee membership, each prospective audit committee
member should evaluate carefully the existing demands on his or her time before ac-
cepting this important assignment. Additionally, if an audit committee member si-
multaneously serves on the audit committee of more than three public companies,
and the listed company does not limit the number of audit committees on which its
audit committee members serve, then in each case, the board must determine that
such simultaneous service would not impair the ability of such member to effectively
serve on the listed company™s audit committee and disclose such determination in the
annual proxy statement or, if the company does not file an annual proxy statement,
in the company™s annual report on Form 10-K filed with the SEC.

7. (a) Each company is required to have a minimum three person audit committee
composed entirely of independent directors that meet the requirements of Section
303A(6).
(b) The audit committee must have a written charter that addresses:
(i) the committee™s purpose”which, at minimum, must be to:
(A) assist board oversight of (1) the integrity of the company™s financial
statements, (2) the company™s compliance with legal and regulatory require-
ments, (3) the independent auditor™s qualifications and independence, and
(4) the performance of the company™s internal audit function and indepen-
dent auditors; and
(B) prepare the report required by the SEC™s proxy rules to be included in the
company™s annual proxy statement, or, if the company does not file a proxy
statement, in the company™s annual report filed on Form 10-K with the SEC;
(ii) the duties and responsibilities of the audit committee set out in Section 303A
(7)(c) and (d); and
(iii) an annual performance evaluation of the audit committee.
(c) As required by Rule 10A-3(b)(2), (3), (4) and (5) of the Securities Exchange Act
of 1934, and subject to the exemptions provided for in Rule 10A-3(c), the audit com-
mittee must:
(i) directly appoint, retain, compensate, evaluate and terminate the company™s
independent auditors;
Commentary: In connection with this requirement, the audit committee must have
the sole authority to approve all audit engagement fees and terms, as well as all sig-
nificant non-audit engagements with the independent auditors. In addition, the inde-
pendent auditor must report directly to the audit committee. This requirement does
not preclude the committee from obtaining the input of management, but these re-
sponsibilities may not be delegated to management. The audit committee must be di-
rectly responsible for oversight of the independent auditors, including resolution of
disagreements between management and the independent auditor and pre-approval
of all non-audit services.
Recent Developments in Corporate Accountability 27


(ii) establish procedures for the receipt, retention and treatment of complaints
from listed company employees on accounting, internal accounting controls or
auditing matters, as well as for confidential, anonymous submissions by listed
company employees of concerns regarding questionable accounting or auditing
matters;
(iii) obtain advice and assistance from outside legal, accounting or other advi-
sors as the audit committee deems necessary to carry out its duties; and
Commentary: In the course of fulfilling its duties, the audit committee may wish to
consult with independent counsel and other advisors. The audit committee must be
empowered to retain and compensate these advisors without seeking board approval.
(iv) receive appropriate funding, as determined by the audit committee, from the
listed company for payment of compensation to the ouside legal, accounting or
other advisors employed by the audit committee.
(d) In addition to the duties set out in Section 303(A)(7)(c), the duties of the audit
committee must be, at a minimum, to:
(i) at least annually, obtain and review a report by the independent auditor de-
scribing: the firm™s internal quality-control procedures; any material issues
raised by the most recent internal quality-control review, or peer review, of the
firm, or by any inquiry or investigation by governmental or professional au-
thorities, within the preceding five years, respecting one or more independent
audits carried out by the firm, and any steps taken to deal with any such issues;
and (to assess the auditor™s independence) all relationships between the inde-
pendent auditor and the company;
Commentary: After reviewing the foregoing report and the independent auditor™s
work throughout the year, the audit committee will be in a position to evaluate the
auditor™s qualifications, performance and independence. This evaluation should in-
clude the review and evaluation of the lead partner of the independent auditor. In
making its evaluation, the audit committee should take into account the opinions of
management and the company™s internal auditors (or other personnel responsible for
the internal audit function). In addition to assuring the regular rotation of the lead
audit partner as required by law, the audit committee should further consider
whether, in order to assure continuing auditor independence, there should be regular
rotation of the audit firm itself. The audit committee should present its conclusions
with respect to the independent auditor to the full board.
(ii) discuss the annual audited financial statements and quarterly financial
statements with management and the independent auditor, including the com-
pany™s disclosures under “Management™s Discussion and Analysis of Financial
Condition and Results of Operations”;
(iii) discuss earnings press releases, as well as financial information and earn-
ings guidance provided to analysts and rating agencies;
Commentary: The audit committee™s responsibility to discuss earnings releases as
well as financial information and earnings guidance may be done generally (i.e., dis-
cussion of the types of information to be disclosed and the type of presentation to be
made). The audit committee need not discuss in advance each earnings release or
each instance in which a company may provide earnings guidance.
(iv) discuss policies with respect to risk assessment and risk management;
28 Corporate Accountability: The New Environment


Commentary: While it is the job of the CEO and senior management to assess and
manage the company™s exposure to risk, the audit committee must discuss guidelines
and policies to govern the process by which this is handled. The audit committee
should discuss the company™s major financial risk exposures and the steps manage-
ment has taken to monitor and control such exposures. The audit committee is not re-
quired to be the sole body responsible for risk assessment and management, but, as
stated above, the committee must discuss guidelines and policies to govern the
process by which risk assessment and management is undertaken. Many companies,
particularly financial companies, manage and assess their risk through mechanisms
other than the audit committee. The processes these companies have in place should
be reviewed in a general manner by the audit committee, but they need not be re-
placed by the audit committee.
(v) meet separately, periodically, with management, with internal auditors (or
other personnel responsible for the internal audit function) and with indepen-
dent auditors
Commentary: To perform its oversight functions most effectively, the audit commit-
tee must have the benefit of separate sessions with management, the independent au-
ditors and those responsible for the internal audit function. As noted herein, all listed
companies must have an internal audit function. These separate sessions may be more
productive than joint sessions in surfacing issues warranting committee attention.
(vi) review with the independent auditor any audit problems or difficulties and
management™s response;
Commentary: The audit committee must regularly review with the independent au-
ditor any difficulties the auditor encountered in the course of the audit work, includ-
ing any restrictions on the scope of the independent auditor™s activities or on access
to requested information, and any significant disagreements with management.
Among the items the audit committee may want to review with the auditor are: any
accounting adjustments that were noted or proposed by the auditor but were
“passed” (as immaterial or otherwise); any communications between the audit team
and the audit firm™s national office respecting auditing or accounting issues pre-
sented by the engagement; and any “management” or “internal control” letter issued,
or proposed to be issued, by the audit firm to the company. The review should also
include discussion of the responsibilities, budget and staffing of the company™s in-
ternal audit function.
(vii) set clear hiring policies for employees or former employees of the inde-
pendent auditors; and
Commentary: Employees or former employees of the independent auditor are often
valuable additions to corporate management. Such individuals™ familiarity with the
business, and personal rapport with the employees, may be attractive qualities when
filling a key opening. However, the audit committee should set hiring policies taking
into account the pressures that may exist for auditors consciously or subconsciously
seeking a job with the company they audit.
(viii) report regularly to the board of directors.
Commentary: The audit committee should review with the full board any issues that
arise with respect to the quality or integrity of the company™s financial statements,
the company™s compliance with legal or regulatory requirements, the performance
and independence of the company™s independent auditors, or the performance of the
internal audit function.
Corporate Accountability and the Audit Committee 29


General Commentary to Section 303A(7)(d): While the fundamental responsibility
for the company™s financial statements and disclosures rests with management and
the independent auditor, the audit committee must review: (A) major issues regard-
ing accounting principles and financial statement presentations, including any sig-
nificant changes in the company™s selection or application of accounting principles,
and major issues as to the adequacy of the company™s internal controls and any spe-
cial audit steps adopted in light of material control deficiencies; (B) analyses pre-
pared by management and/or the independent auditor setting forth significant
financial reporting issues and judgments made in connection with the preparation of
the financial statements, including analyses of the effects of alternative GAAP meth-
ods on the financial statements; (C) the effect of regulatory and accounting initia-
tives, as well as off-balance sheet structures, on the financial statements of the
company; and (D) the type and presentation of information to be included in earnings
press releases (paying particular attention to any use of “pro forma,” or “adjusted”
non-GAAP, information), as well as review any financial information and earnings
guidance provided to analysts and rating agencies.
General Commentary to Section 303A(7): To avoid any confusion, note that the
audit committee functions specified in Section 303A(7) are the sole responsibility of
the audit committee and may not be allocated to a different committee.
(e) Each listed company must have an internal audit function.
Commentary: Listed companies must maintain an internal audit function to provide
management and the audit committee with ongoing assessments of the company™s
risk management processes and system of internal control. A company may choose
to outsource this function to a firm other than its independent auditor.20


CORPORATE ACCOUNTABILITY AND THE AUDIT COMMITTEE
The Role of the Audit Committee
The audit committee has a critical role within the framework of corporate ac-
countability since the jurisdiction of the committee is to oversee and monitor the
activities of the corporation™s financial reporting system and the internal and ex-
ternal audit processes. The audit committee assists the board of directors with the
development and maintenance of the corporate accountability framework, because
the committee compels the board to be accountable for its stewardship account-
ability. Thus the audit committee helps create an environment in which the activ-
ities of corporate management are subject to scrutiny.
As Harold M. Williams, former chairman of the SEC, asserted:
It should be evident, but perhaps bears repeating, that integrity in reporting financial
data is vital both to an efficient and effective securities market and to capital forma-
tion. One key to increasing public confidence in that data long advocated by many
segments of the financial community, including public accounting firms, is more
direct involvement by boards of directors in the auditing process and the integrity
of reported financial information. The vehicle which the Securities and Exchange

20
Securities and Exchange Commission Release No. 34-47672, File No. SR-NYSE-2002-33, Pro-
posed Rule Change Relating to Corporate Governance (Washington DC: April 11, 2003). See also
SEC Release No. 34-47672, File No. SR-NASD-2002-141, for the NASD, Proposed Rule Change Re-
lating to Corporate Governance.
30 Corporate Accountability: The New Environment


Commission, the New York Stock Exchange and an increasing number of public cor-
porations have turned to has been the independent audit committee.21

As a standing committee appointed by the board of directors, the audit commit-
tee is directly accountable for its actions to the board. The audit committee operates
in an advisory capacity. Thus the audit committee has limited authority, because a
final decision concerning its recommendations is made by the board. The board
seeks guidance from the audit committee in formulating or amending the financial
accounting policies to service properly the needs of its various constituencies.
With respect to the expectations of the various constituencies, Russell E.
Palmer, former managing partner of Touche Ross and Co. (now Deloitte and
Touche), stated:

Every audit committee will be expected to weigh the appropriateness of the corpora-
tion™s accounting policies as they apply to the corporation and its industry. It seems rea-
sonable that committee members will be expected to assess and be satisfied with the
corporation™s entire disclosure system”the financial statements, the published stock-
holders™ reports, and even discussions between management and the financial media.22

To further illustrate the role of the audit committee, Exhibit 1.5 diagrams the
direct relationship between the committee and its constituencies in the internal
corporate environment.

Important Surveys
In their survey of audit committees, Joseph F. Castellano, Harper A. Roehm, and
Albert A. Vondra found that the corporate community is building a strong case for
self-regulation by complying with the recommendation of the Treadway Com-

<<

. 7
( 82 .)



>>