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mission. Such compliance has improved the quality of financial reporting.23 Their
survey results are further supported by Ivan Bull. He found that in a survey of 13
chairpersons of publicly held corporations in Illinois, “most boards were either al-
ready following or have since implemented the Treadway Commission recom-
mendations” to prevent fraudulent misstatements in their financial statements.
“Audit committee chairpeople generally believe their committees are ˜informed,
vigilant, and effective overseers™ described in the Treadway report.”24
In another survey of audit partners, directors of internal auditing, and chief
financial officers associated with audit committees of 90 U.S. corporations,
Lawrence P. Kalbers and Timothy J. Fogarty investigated the relationship between
audit committee effectiveness and the types and extent of the committee™s power.
They concluded:

21
Harold M. Williams, “Audit Committees”The Public Sector™s View,” Journal of Accountancy 144,
No. 3 (September 1977), p. 71.
22
Russell E. Palmer, “Audit Committees”Are They Effective? An Auditor™s View,” Journal of Ac-
countancy 144, No. 3 (September 1977), p. 77.
23
Joseph F. Castellano, Harper A. Roehm, and Albert A. Vondra, “Audit Committee Compliance with
the Treadway Commission Report: A Survey,” OHIO CPA Journal 48, No. 4 (Winter 1989), p. 42.
24
Ivan Bull, “Board of Director Acceptance of Treadway Responsibilities,” Journal of Accountancy
171, No. 2 (February 1991), p. 67.
Corporate Accountability and the Audit Committee 31



Exhibit 1.5 The Audit Committee™s Accountability Relationship

External environment ” external users of accounting information



Independent Credit Regulatory The public
Stockholders
auditors grantors agencies in general
Maintains independence




Board of
directors
Establishes and maintains
corporate policies and provides
information on its stewardship
accountability.

Oversees and monitors the
Audit
audit process
committee




Internal Chief Chief
auditors executive financial
officer officer


Internal environment




This study suggests that the fundamental types of power needed by audit committees
to perform effectively are (1) institutional support, (2) actual authority (written and
implied), and (3) diligence. With the possible exception of written mandates (such as
audit committee charters), these factors are especially difficult to evaluate with any
traditional means of regulation. Perhaps more effective regulation should aim for
more substantive reviews of power within the organization.25


25
Lawrence P. Kalbers and Timothy J. Fogarty, “Audit Committee Effectiveness: An Empirical Inves-
tigation of the Contribution of Power,” Auditing: A Journal of Practice & Theory 12, No. 1 (Spring
1993), p. 45. For additional information, consult Dana Wechsler, “Giving the Watchdog Fangs,”
Forbes 144 (November 13, 1989), pp. 130, 132“133; Nelson Luscombe, “More Power to Audit Com-
mittees” CA Magazine 122, No. 5 (May 1989), pp. 26“37; Dorothy A. McMullen, “Audit Committee
Performance: An Investigation of the Consequences Associated with Audit Committees,” Auditing:
A Journal of Practice & Theory 15, No. 1 (Spring 1996), pp. 87“103; Donald J. Kirk and Arthur
Siegel, “How Directors and Auditors Can Improve Corporate Governance,” Journal of Accountancy
181, No. 1 (January 1996), pp. 53“57; Zabihollah Rezaee, “Corporate Governance and Accountabil-
ity: The Role of Audit Committees,” Internal Auditing 13, No. 1 (Summer 1997), pp. 27“41; and
Michael A. Mackenzie, “The Evolving Board: The Mechanism of Board Oversight,” Canadian Busi-
ness Law Journal 26 (1996), pp. 140“144. Also see additional suggested readings.
32 Corporate Accountability: The New Environment


The chief executive
The Audit Committee and the Chief Executive Officer
officer has an obligation not only to the board but also to the standing committees
of the board. The chief CEO is responsible primarily for recommending major pol-
icy decisions to the board of directors. Since the CEO participates in the decisions
concerning the financial accounting policies, he or she should have direct com-
munication with the audit committee.
However, it is essential that the audit committee be totally independent from
the CEO because he or she is a “managing director.” As a managing director, the
CEO participates in the general administration of the corporation as well as as-
suming ultimate responsibility for the decisions.
Based on a close examination of the audit committees of 13 corporations listed
on the NYSE, Michael L. Lovdal found that:

Effective audit committees permit the chief executive to attend by invitation only. . . .
After all, he is the best source concerning questions related to the business and he can
ensure quick action on committee requests. In achieving the appropriate relationship
with the chief executive, a key ingredient is the quality of the audit committee chair-
man. He must have both the sensitivity to know when to bring the CEO into the
group™s deliberations and the strength to stand up to him when the committee wants
to pursue an inquiry or change policy.26

In short, the audit committee should determine its own agenda items, which should
not be based on the chief executive officer™s prerogatives. As Ivan Bull observed:

Concern about other environmental factors, such as legal liability, also may have in-
fluenced board agendas and operating practices. The board™s practice of allowing
and listening to dissent and advice from outside members is healthier than the pop-
ular belief that CEOs dominate passive boards.27


The Audit Committee and the Chief Financial Officer28 In most corpora-
tions, the chief financial officer (CFO) is responsible for the functions of the con-
troller. In turn, the CFO is accountable to the president for the conduct of the
various administrative functions of the controller. Although the controller is re-
sponsible for the general administration and supervision of the accounting opera-
tions, the CFO has executive responsibility for the financial accounting policies.
Since the audit committee is responsible for assuring that management fulfills
its responsibilities in the preparation of the financial statements, the CFO should



26
Michael L. Lovdal, “Making the Audit Committee Work,” Harvard Business Review 55
(March“April 1977), p. 110.
27
Bull, “Board of Director Acceptance,” p. 71. Also see J. Michael Cook, “The CEO and the Audit
Committee,” Chief Executive, No. 76 (April 1993), pp. 44“47.
28
For further discussion, see Louis Braiotta, Jr., and Jay R. Olson, “Guiding the Audit Committee: A
CFO™s Concern,” Financial Executive 51, No. 9 (September 1983), pp. 52“54. See also Chapter 13 for
a discussion of the audit committee™s review of the quarterly reporting process.
Corporate Accountability and the Audit Committee 33


consult with the committee in order to coordinate the financial accounting activi-
ties. Thus the audit committee should have a dialogue with the CFO to consider
any questions concerning the financial reporting practices. For example, if the
CFO has certain reservations or exceptions to certain accounting policies and prac-
tices, the audit committee would recommend the necessary course of action sub-
sequent to its consultation with the independent auditors.

The internal audit
The Audit Committee and the Internal Audit Group
executive is essentially responsible for the establishment and maintenance of an
effective and efficient system of internal auditing. With respect to the audit com-
mittee™s involvement with the internal audit group, Lovdal points out:

The internal audit group can be an avenue for the committee in reaching the source
of a variety of problems. One committee I examined uses internal auditors regularly
for investigations in such areas as computer security, transfer pricing, and capital
budgeting. For these activities, the committee should deal directly with the head of
internal audit, rather than solely through other finance or control executives, and
should make itself knowledgeable about the organization, staffing, and budgets of
the internal audit department.29

The reporting responsibility of the internal audit group varies from one organi-
zation to the next. For example, the director of internal auditing may report to the
controller or CFO and meet with the audit committee on a separate or joint basis.
However, the director of internal auditing should have access to the audit commit-
tee to provide for a forum whereby the internal audit group can resolve question-
able matters between the audit staff and corporate management. (See Chapter 9.)
Exhibit 1.6 presents more recent academic research studies. To the extent that
the audit committee maintains an independent posture in the corporate environ-
ment, the committee will represent a check on the corporate management with re-
spect to its corporate power and stewardship accountability. The primary objective
is to foster the accountability relationship between the audit committee and the
representatives of management and thereby create an environment in which man-
agement will be responsive to its constituencies.
Subsequent to the aforementioned proxy statement seasons, a number of ac-
counting scandals and the demise of a large international accounting firm provided
the impetus for the Sarbanes-Oxley Act of 2002 and proposed amendments to the
SRO™s listing standards. Exhibit 1.7 presents a summary of selected sections and
titles of the act. Each section is presented in Chapter 2. Also, Exhibit 1.8 summa-
rizes the SEC releases to implement the sections of the Sarbanes-Oxley Act avail-
able at the time of this writing. Exhibit 1.9 contains a corporate accountability
self-assessment checklist.




29
Lovdal, “Making the Audit Committee Work,” p. 111.
34 Corporate Accountability: The New Environment



Exhibit 1.6 Summaries of Recent Research Studies

DeZoort, F. Todd, Dana R. Hermanson, and Richard W. Houston, “Audit Committee Sup-
port for Auditors: The Effects of Materiality Justification and Accounting Precision.” Jour-
nal of Accounting and Public Policy 22, (2003), pp. 175“199.
Summary: The authors find that, in the context of auditor-management disagreements,
independent auditors and audit committees need to discuss the qualitative aspects of
materiality with respect to undrecorded adjustments. Additionally, the authors con-
clude that both accounting and auditing standard setters should consider approaches to
enhance accounting estimates in the financial reporting process, including communi-
cations with audit committees. Finally, they find that audit committees with CPAs pro-
vide greater support for independent auditors.

Klein, April, “Audit Committees, Board of Director Characteristics, and Earnings Man-
agement.” Journal of Accounting & Economics 33 (2002), pp. 375“400.
Summary: Klein concludes that reductions in the independence of boards of directors
or audit committees cause large increases in abnormal accruals. The results suggest that
boards of directors that are more independent of the CEO are more effective in moni-
toring earnings management in the financial reporting process.

Beasley, Mark S. and Steven E. Salterio, “The Relationship between Board Characteristics
and Voluntary Improvements in Audit Committee Composition and Experience.” Contem-
porary Accounting Research 18, No. 4 (Winter 2001), pp. 539“570.
Summary: Beasley and Salterio find that Canadian firms that voluntarily include more
outside directors on the audit committee than the minimum mandated by Canadian cor-
porate law have larger boards of directors with more outside directors and thus
are more likely to segregate the board chair and CEO/president positions. Like-
wise, audit committees with financial reporting knowledge and experience and
larger boards with outside members are less likely to be chaired by the CEO/president.
Thus the researchers conclude that one person serving as both chairman and CEO/pres-
ident increases the potential for less effective monitoring by the audit committee.

Klein, April, “Economic Determinants of Audit Committee Independence.” Accounting
Review 77, No. 2 (April 2002), pp. 435“452.
Summary: Klein reports that audit committee independence increases with board size
and the percentage of outsiders on the board of directors. However, audit committee in-
dependence decreases with an increase in a firm™s growth opportunities or when a firm
reports net losses. Klein confirms the findings of the Blue Ribbon Committee on Im-
proving the Effectiveness of Corporate Audit Committees that “one size doesn™t fill all”
when it comes to audit committees. The results suggest that the stock exchanges should
allow boards flexibility with respect to audit committee composition.
Carcello, Joseph V. and Terry L. Neal, “Audit Committee Composition and Auditor Re-
porting.” Accounting Review 75, No. 4 (October 2000), pp. 453“467.
Summary: Carcello and Neal find that the greater the percentage of affiliated directors
on the audit committee, the lower the probability the auditor will issue a going-concern
report. Thus their evidence supports the proposition that the audit committee should be
composed of independent, outside directors.
Beasley, Mark S., Joseph V. Carcello, Dana R. Hermanson, and Paul D. Lapides, “Fraud-
ulent Financial Reporting: Consideration of Industry Traits and Corporate Governance
Mechanisms.” Accounting Horizons 14, No. 4 (December 2000), pp. 441“454.
Corporate Accountability and the Audit Committee 35



Summary: The authors confirm earlier findings that fraudulent firms and no-fraud
firms differ to the extent that audit committees exist and such committees are indepen-
dent, including the board™s independence from management. With the identification of
no-fraud industry benchmarks (e.g., number of audit committee meetings and internal
audit experience), they find that the sample fraud firms have weak governance mecha-
nisms. Moreover, independent auditors should consider the industry context with re-
spect to their fraud risk assessment on client audit engagements.
Abbott, Lawrence J. and Susan Parker, “Auditor Selection and Audit Committee Charac-
teristics.” Auditing: A Journal of Practice and Theory 19, No. 2 (Fall 2000), pp. 47“66.
Summary: The authors conclude that the requirement for financial experts on audit
committees is more likely to change the structure and focus of audit committee dis-
cussions about the quality of the financial reporting process. Their results suggest that
audit committee members who are financially literate are more likely to focus on re-
porting treatments that are prominent in the press and nonrecurring, while financial ex-
perts are more likely to focus on the relevance of reporting treatments as well as
recurring activities.
Abbott, Lawrence J. and Susan Parker, “Auditor Selection and Audit Committee Charac-

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