| The choice of the title is strictly intentional. If you recognize
it, then you know that the question dictates the answer. If you
do not, you soon will because it is part of a process that will
set a new paradigm for investor protection and corporate
accountability in the post-Enron era.
Audit committees have long been part of the traditional framework
of corporate governance. Traditionally, membership on this
committee reflected an acknowledgment of senior status bestowed
upon independent directors who had a little more time to devote
to such matters and whom the board wished to honor.
The seeds of change were sown in the summer of 1998 when
Securities and Exchange Commission Chairman Arthur Levitt
excoriated a process that, in his words, had become "a game of
nods and winks" involving the analysts, the auditors and those in
charge of a corporation's affairs. Levitt lamented that
"integrity may belosing out to illusion." Commenting on five
"hocus-pocus" categories that were flagrant distortions of the
financial reporting process, Levitt introduced a nine-point plan,
which focused on the requirement that corporate audit committees
take responsibility for their companies and "function as the
ultimate guardian of investor interests and corporate
accountability."
The New York Stock Exchange and the National Association of
Securities Dealers, responding to that call-to-arms, established
the Blue Ribbon Committee on Improving the Effectiveness of
Corporate Audit Committees. The committee released a 71-page
report setting forth 15 far-reaching recommendations and
principles for audit committee conduct and best practices. In
traditional corporate fashion, the Blue Ribbon Committee's
recommendations were politely hailed as "important," long overdue
changes and were given the traditional lip service by the vast
majority of reporting corporations. Yet in light of the Enron and
World Com developments, Levitt's Cassandra-like warnings, echoed
in the Blue Ribbon Committee's report, are now hauntingly prophetic. While the committee's recommendations are
not legally mandated, it is likely that they will soon become so.
In structure, the Blue Ribbon Committee endeavored to set apart
the audit committee as one support of a "three-legged stool" of
checks and balances that would mandate transparent reporting and
financial statements that are not misleading. The committee,
however, went even further, determining that the audit committee
"must be 'first among equals' in this process & hellip; and hence
the ultimate monitor of the process."
This is a daunting change in responsibilities. First, to
institutionalize this process, the Blue Ribbon Committee directed
audit committee members to be literate in financial matters and
to adopt a full written charter governing their responsibilities,
processes and the like.
After establishing procedural safeguards, the Blue Ribbon
Committee specified the substantive independence of the audit
committee. First, it required the outside auditors to be
ultimately accountable to the audit committee. More difficult,
however, is the recommendation that the auditors discuss with the
audit committee their judgments, not just about the acceptability
of the accounting principles applied in financial reporting, but
also about the quality of such principles and, where appropriate,
the audit committee should retain independent counsel and
advisers.
Finally, the Blue Ribbon Committee requested that an audit
committee submit a letter with each annual report disclosing
whether or not it had a discussion of the quality of accounting
principles with the auditors, so that hey believed "that the
company's financial statements are fairly presented."
The reality of this process, however, is that while this new
system of "checks and balances" mirrors in traditional fashion
the framework of our own Constitution, this audit committee
structure represents a new paradigm for American corporate
governance. It very much contemplates that, to be effective and
carry out its role, the audit committee, in a startlingly
untraditional way, may well be at odds with policies that
management may prefer and perhaps even with the remainder of the
board itself.
Clearly, technical compliance with accounting rules will no
longer be good enough for the audit committee. Thus, if a company
were, in the future, to endeavor to use those techniques so
highly criticized by former SEC chairman Levitt - namely "big
bath" accounting charges, maintenance of "cookie jar" reserves,
materiality tricks and "creative" acquisition accounting - it is
likely that it could do so only over the strenuous dissent of the
audit committee.
While not addressed by the Blue Ribbon Committee's report, absent
the business community's good-faith compliance with the spirit of
the committee's recommendations, it is likely that congressional
anger over current reporting practices will result in a
curtailment of the decision-making independence U.S. companies
currently enjoy. Specifically, while several initiatives have
been proposed by Congress and by administrative agencies to alter
existing auditing practices, we are also beginning to see
indications that Congress will seek to interpose itself into the
decision-making processes of boards of directors.
By way of example, the Corporate Auditing Responsibility and
Transparency Act of 2002, H.R. 3763, seeks to establish yet
another public regulatory organization to perform quality reviews
of public accounting activities. This "Big Brother" type of
agency would obviously not act in a vacuum and would have to make
its examinations in the context of the specific audits that such
accountants perform on specific companies. In this fashion, one
would find federal agencies beginning to move into the role that
has not been performed sufficiently well by corporations' audit
committees.
This bill would give the SEC authority to "bar" individuals from
serving as officers or directors of public companies, among other
things, if the agency were to determine that they were
"substantially unfit" for service. Such an intervention by the
federal government to solve this failure of our corporate culture
is also a major incursion into the fundamental principle of
shareholder democracy that has been a bulwark of corporate
(Editor's Note: The Sarbanes-Oxley Act of 2002 was passed after
this article was written and the changes mentioned above have
been incorporated into the new law.)
In this light, the Blue Ribbon Committee's recommendations
constitute not only a latent source of liability for audit
committee directors, but also serve as a legitimate, focused
solution to the failures of corporate governance. If properly
implemented, they could preempt the loss of board freedoms that
Congress is currently contemplating.
What will this mean for the political collegiality that is
supposed to exist in the traditional boardroom? Will audit
committee directors be able to maintain their seats in the face
of such strong differences? While use of professional audit
committee members should not be necessary, independent legal and
financial advice from someone who could audit the audit committee
is recommended, not only to assure the board and investors that
the committee is doing its job, but so committee members will
know that they are not exposing themselves to severe liability.
Under current circumstances it is blatantly obvious that this
independent advice should not
come from the Big Four accounting firms or corporate SEC counsel.
Corporations should adopt not only a carefully crafted charter,
but also detailed checklists to carry out the charter; calendars
to execute the checklists; guidelines and interpretations;
up-to-date research materials; documentation verifying director
independence and financial background; guidelines to ensure that
the audit committee is protected from undue pressure from
management or the remaining board; mechanisms to require
disclosure of and the reasons for the replacement of audit
committee directors; and disclosed procedures for setting
compensation levels and methods. They should also seek oversight
advice from competent professionals so that they will be able to
document diligence in audit committee practices. These documents
cannot be off-the-shelf boilerplate. They must be tailored to the
corporation, the specifics of its industry, and its current
situation.
The Blue Ribbon Committee has recommended that listed companies
with a market cap of $200 million or more have at least one audit
committee member with "accounting or related financial management
expertise, "but this requirement should apply to all listed
companies. All members should possess these skills, and the
committee chairman should also have a strong background in and
understanding of the audit and financial presentation processes.
Audit committees should have on retainer their own independent
counsel and accounting consultants. The removal or resignation of
an audit committee member should be reported to the SEC and
published in the proxy, together with a statement of reasons for
the action.
One may argue that the inclusion of these guidelines and
recommendations is at the leading edge of today's best practices.
However, tomorrow a failure to observe such matters may likely be
nothing less than pure negligence.
We are now in a new time of financial reporting innovation. By
embracing these requirements, we can better ensure the
accountability and reliability of our system. By rejecting them,
we acquiesce to the proliferation of the Enron- and WorldCom-type
situations and the potential for loss of corporate
self-governance.
* John J. Whyte, president of Whyte Worldwide PCE, provides
professional corporate executive services to companies. Having
therefore held senior executive, director, and advisory positions
for domestic and international, public and private companies in a
number of industries, he is an expert in corporate governance.
Because Mr. Whyte was also partner-in-charge of operations and
consulting of a prominent regional CPA firm and served on and
chaired committees of professional organizations, such as the
AICPA, he has knowledge of all sides of this critical issue. He
is currently audit committee chair for Commonwealth Telephone
Enterprises, a
CLEC/ILEC/ISP. (Contact: whyte wpce@cs.com)
Richard L. Wise is a member of the law firm Eckert Seamans Cherin
& Mellott, based in their Boston office. Mr. Wise concentrates
his practice in advising emerging and growth companies in complex
business transactions and strategies, including issues involved
with mergers and acquisitions, business reorganization, and
transnational trade and project finance. He also serves as
corporate counsel to a variety of companies. Mr. Wise is also a
student of international relations in the Fletcher School of Law
and Diplomacy's global master
of arts program. (Contact: richard.wise@escm.com)
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