Chicago CFO Advisory CouncilChicago CFO Advisory Council

December 9, 1999December 9, 1999

Update on the Blue Ribbon Update on the Blue Ribbon Committee on Improving Committee on Improving

the Effectiveness of the Effectiveness of Audit CommitteesAudit Committees

• Improve audit committee effectivenessImprove audit committee effectiveness

• Increase oversight diligence by audit Increase oversight diligence by audit committeescommittees

• Reduce cases of improper financial reporting Reduce cases of improper financial reporting as a result of these improved audit committee as a result of these improved audit committee practices.practices.

Objectives

The Three Legged Stool of Financial Reporting

1. Company financial management2. Board including the audit committee3. External auditors

Each has a role. Each has certain specialties and capabilities in terms of expertise, time and depth of familiarity.

• Independence of Audit Committee Independence of Audit Committee

Members - Self Regulating Org :SROMembers - Self Regulating Org :SRO

• Composition of Audit CommitteeComposition of Audit Committee

• Qualifications of Audit Committee Qualifications of Audit Committee

membersmembers

• Adoption of Audit Committee Adoption of Audit Committee

CharterCharter

Blue Ribbon Panel Recommendations

– SROSRO

– SROSRO

– SROSRO

– SROSRO

• Disclosure in Proxy Statement about Disclosure in Proxy Statement about

Charter and compliance therewithCharter and compliance therewith

• Outside auditor is accountable to Outside auditor is accountable to

Board of DirectorsBoard of Directors

• Outside auditors provide Audit Outside auditors provide Audit

Committee with written Statement on Committee with written Statement on

IndependenceIndependence

Blue Ribbon Panel Recommendations

– SECSEC

– SROSRO

– SROSRO

• Outside auditors discuss with Audit Outside auditors discuss with Audit

Committee their judgement about Committee their judgement about

quality of accounting principlesquality of accounting principles

• Audit Committee Letter in Annual Audit Committee Letter in Annual

ReportReport

• Quarterly SAS 71 reviews and Quarterly SAS 71 reviews and

discussion of results with Audit discussion of results with Audit

CommitteeCommittee

Blue Ribbon Panel Recommendations

– AICPAAICPA

– SECSEC

– SEC/AICPASEC/AICPA

Quarterly SAS Reviews and Discussions of Results with Audit

Committee - #10 (SEC)• Requires that outside auditor conduct a SAS 71 interim Requires that outside auditor conduct a SAS 71 interim

financial review prior to company filing its Form 10-Qfinancial review prior to company filing its Form 10-Q

• Recommends that SAS 71 be amended to require outside Recommends that SAS 71 be amended to require outside

auditors to discuss significant issues with at least the auditors to discuss significant issues with at least the

chairman of the Audit Committee, including:chairman of the Audit Committee, including:• significant adjustmentssignificant adjustments• management judgements and accounting estimatesmanagement judgements and accounting estimates• significant new accounting policiessignificant new accounting policies• disagreements with managementdisagreements with management

• Proposed amending SAS 71 to require quarterly Proposed amending SAS 71 to require quarterly

discussions with the AC prior to the filing of the 10-Q discussions with the AC prior to the filing of the 10-Q

• Encourages this discussion prior to public Encourages this discussion prior to public

announcement of interim resultsannouncement of interim results

• The auditor would have to discuss the items The auditor would have to discuss the items

described in SAS 61 or be satisfied that those matters described in SAS 61 or be satisfied that those matters

have been discussed with the AC by managementhave been discussed with the AC by management

ASB Actions

• Interim financial statements should be Interim financial statements should be

reviewed by independent auditors before reviewed by independent auditors before

filing 10-Q and 10-QSB.filing 10-Q and 10-QSB.

SEC Actions

Letter should disclose whether or not:Letter should disclose whether or not:

Audit Committee Letter in Annual Report - #9 (SEC)

• Management has reviewed the audited financials Management has reviewed the audited financials

with the Audit Committee, including a discussion of with the Audit Committee, including a discussion of

the quality of the accounting principles applied, etc.the quality of the accounting principles applied, etc.

• The outside auditors have discussed with the Audit The outside auditors have discussed with the Audit

Committee their judgements regarding the quality of Committee their judgements regarding the quality of

principles applied, etc.principles applied, etc.

Audit Committee Letter in Annual Report - #9 (SEC)

• Members of the Audit Committee have discussed Members of the Audit Committee have discussed

information disclosed to them by management and information disclosed to them by management and

outside auditorsoutside auditors

• The Audit Committee, in reliance on the above, believe The Audit Committee, in reliance on the above, believe

that the company’s financials are fairly presented, in all that the company’s financials are fairly presented, in all

material respects, in conformity with GAAP material respects, in conformity with GAAP

• It is recommended that the SEC adopt a “Safe Harbor” It is recommended that the SEC adopt a “Safe Harbor”

applicable to any disclosure in this recommendationapplicable to any disclosure in this recommendation

Letter should disclose whether or not:Letter should disclose whether or not:

• Proxy statements must include an AC report that Proxy statements must include an AC report that

discloses:discloses:

– whether the AC reviewed and discussed certain whether the AC reviewed and discussed certain

matters with management and the auditorsmatters with management and the auditors

– whether the AC recommended to the Board that the whether the AC recommended to the Board that the

audited financial statements be included in the Annual audited financial statements be included in the Annual

Report on Form 10-K or 10-KSBReport on Form 10-K or 10-KSB

SEC Actions

• Discuss quality, not just the acceptability of Discuss quality, not just the acceptability of

accounting principles as applied in financial reportingaccounting principles as applied in financial reporting

• Include:Include:

Outside Auditors Discuss with Audit Committee Their Judgement About Quality

of Accounting Principles - #8 (AICPA)

• clarity of financial disclosuresclarity of financial disclosures• degree of aggressiveness or conservatism of degree of aggressiveness or conservatism of

accounting principles and underlying estimatesaccounting principles and underlying estimates• other significant management decisions regarding other significant management decisions regarding

financial disclosuresfinancial disclosures

• The ASB has proposed amending SAS 61 which The ASB has proposed amending SAS 61 which

would require a discussion of the quality of would require a discussion of the quality of

accounting principles with the AC each yearaccounting principles with the AC each year

• The ASB deleted the terms “aggressive” and The ASB deleted the terms “aggressive” and

“conservative” due to the subjectivity of the “conservative” due to the subjectivity of the

termsterms

ASB Actions

• Charter to specify that Audit Committee is responsible Charter to specify that Audit Committee is responsible

for obtaining a formal written Statement of for obtaining a formal written Statement of

Independence from outside auditorsIndependence from outside auditors

• Statement should delineate all relationships between Statement should delineate all relationships between

auditor and company and be consistent with the auditor and company and be consistent with the

Independence Standards Board (Standard 1)Independence Standards Board (Standard 1)

Outside Auditors Provide Audit Committee with Written Statement

on Independence - #7 (SRO)

• Audit Committee is responsible for actively engaging Audit Committee is responsible for actively engaging

in a dialogue with the auditor with respect to any in a dialogue with the auditor with respect to any

disclosed relationships or services that may impact the disclosed relationships or services that may impact the

objectivity or independence of the auditorobjectivity or independence of the auditor

Outside Auditors Provide Audit Committee with Written Statement

on Independence - #7 (SRO)

NYSE/SEC Actions

• NYSE adopts this recommendationNYSE adopts this recommendation

• SEC requires proxy statements to include SEC requires proxy statements to include audit committee report discussing whether audit committee report discussing whether the audit committee has received disclosures the audit committee has received disclosures from independent auditors required by ISB from independent auditors required by ISB Standard No. 1, and discussed with the Standard No. 1, and discussed with the auditors the auditor’s independence (these auditors the auditor’s independence (these disclosures to be protected by safe harbor)disclosures to be protected by safe harbor)

• Charter to specify that outside auditor is ultimately Charter to specify that outside auditor is ultimately

accountable to Board of Directors and the Audit accountable to Board of Directors and the Audit

Committee as representatives of shareholdersCommittee as representatives of shareholders

• The above representatives have ultimate authority and The above representatives have ultimate authority and

responsibility to select, evaluate and where appropriate responsibility to select, evaluate and where appropriate

replace the outside auditor or to nominate an outside replace the outside auditor or to nominate an outside

auditor to be proposed for shareholder approval in Proxyauditor to be proposed for shareholder approval in Proxy

Outside Auditor is Accountable to Board of Directors - #6 (SRO)

• Similar to current practices/NYSE adopts Similar to current practices/NYSE adopts

this recommendationthis recommendation

NYSE Actions

• Company is required to have its Audit Committee Company is required to have its Audit Committee

disclose in its annual Proxy Statement whether Audit disclose in its annual Proxy Statement whether Audit

Committee has adopted a formal written CharterCommittee has adopted a formal written Charter

• Audit Committee to also state whether it satisfied its Audit Committee to also state whether it satisfied its

responsibilities in compliance with Charterresponsibilities in compliance with Charter

Disclosure in Proxy of Charter and Compliance Therewith - #5 (SEC)

• Charter is to be disclosed triennially in annual report or Charter is to be disclosed triennially in annual report or

proxy and in any year after significant amendments are proxy and in any year after significant amendments are

made to the Chartermade to the Charter

• It is recommended that SEC adopt a “Safe Harbor” It is recommended that SEC adopt a “Safe Harbor”

applicable to all disclosures in this Recommendation #5applicable to all disclosures in this Recommendation #5

Disclosure in Proxy of Charter and Compliance Therewith - #5 (SEC)

• A copy of the AC charter should be filed with A copy of the AC charter should be filed with

the SEC every 3 yearsthe SEC every 3 years

• The SEC did NOT propose to require The SEC did NOT propose to require

companies to disclose whether the AC was in companies to disclose whether the AC was in

compliance with its charter to avoid “skimpy, compliance with its charter to avoid “skimpy,

broadly-worded and vague charters”broadly-worded and vague charters”

• SEC adopts safe harborSEC adopts safe harbor

SEC Actions

• Adopt a formal, written Charter that is approved by Adopt a formal, written Charter that is approved by

the full boardthe full board

• Specify the scope of responsibilities and how those Specify the scope of responsibilities and how those

responsibilities are carried out, including structure, responsibilities are carried out, including structure,

processes and membership requirementsprocesses and membership requirements

• Review and reassess the adequacy of the Charter on Review and reassess the adequacy of the Charter on

an annual basisan annual basis

Adoption of Audit Committee Charter - #4 (SRO)

• NYSE adopts this recommendationNYSE adopts this recommendation

• NYSE requires annual confirmation of NYSE requires annual confirmation of

any determination that board makes any determination that board makes

regarding the annual review of the charterregarding the annual review of the charter

NYSE Actions

• Audit Committee should be comprised of a minimum Audit Committee should be comprised of a minimum

of three directorsof three directors

• Each member should be financially literate or become Each member should be financially literate or become

financially literate within a reasonable period of time financially literate within a reasonable period of time

after appointmentafter appointment

• One member of Committee should have accounting or One member of Committee should have accounting or

related financial management expertiserelated financial management expertise

Qualifications of Audit Committee Members - #3 (SRO)*

* For Companies with market capitalization over $200 million

• NYSE adopts this recommendation, but REJECTS NYSE adopts this recommendation, but REJECTS

$200 million market cap recommendation$200 million market cap recommendation

• NYSE requires annual confirmation of any NYSE requires annual confirmation of any

determination that board makes regarding the determination that board makes regarding the

financial literacy of audit committee members and the financial literacy of audit committee members and the

accounting or financial management background of at accounting or financial management background of at

least one audit committee memberleast one audit committee member

NYSE Actions

• All listed companies with market capitalization All listed companies with market capitalization

above $200 million should have Audit Committee above $200 million should have Audit Committee

comprised solely of independent directorscomprised solely of independent directors

Composition of Audit Committee - #2 (SRO)

In addition to compliance with definition of independence (in Recommendation #1):

Independence of Audit Committee Members - #1 (SRO)*

Committee members are considered independent Committee members are considered independent if they have no relationship with the corporation if they have no relationship with the corporation that may interfere with the exercise of their that may interfere with the exercise of their independence from management.independence from management.

* For Companies with market capitalization over $200 million

• Director being employed by corporation (or affiliates) Director being employed by corporation (or affiliates)

for current and any of the past 5 yearsfor current and any of the past 5 years

• Director receiving compensation other than for Board Director receiving compensation other than for Board

serviceservice

• Director being related to anyone who has been Director being related to anyone who has been

executive officer of the corporation in any of the past 5 executive officer of the corporation in any of the past 5

yearsyears

Independence of Audit Committee Members - #1 (SRO)

Examples of conflicts of independence are:

• Director being a principal or executive officer of an Director being a principal or executive officer of an

entity to which the corporation made or received entity to which the corporation made or received

payments in amounts that are significant to the payments in amounts that are significant to the

corporation or entitycorporation or entity

• Director being employed as executive of another Director being employed as executive of another

company where any of the corporation’s executives serve company where any of the corporation’s executives serve

on that company’s Compensation Committeeon that company’s Compensation Committee

Independence of Audit Committee Members - #1 (SRO)

Examples of conflicts of independence, continued:

• Each exchange adopted a tougher definition of Each exchange adopted a tougher definition of

independenceindependence

• Each provide for a “board override” for one Each provide for a “board override” for one

member to be appointed to the AC who fails the member to be appointed to the AC who fails the

definition of independentdefinition of independent

NYSE/NASD/AMEX Actions

• NYSE/AMEX/NASDAQ companies should NYSE/AMEX/NASDAQ companies should

disclose certain information about any AC disclose certain information about any AC

member who in not “independent”, as defined in member who in not “independent”, as defined in

listing requirementslisting requirements

• Despite concerns, small businesses NOT Despite concerns, small businesses NOT

EXEMPT from the new requirementsEXEMPT from the new requirements

NYSE/NASD/AMEX Actions

• The Audit Committees key role in monitoring The Audit Committees key role in monitoring

the other component parts of the audit processthe other component parts of the audit process

• Independent communication and information Independent communication and information

flow with internal auditorsflow with internal auditors

• Independent communication and information Independent communication and information

flow with outside auditorsflow with outside auditors

Audit Committees Best Practices

• Candid discussions with management, the Candid discussions with management, the

internal auditor and outside auditors regarding internal auditor and outside auditors regarding

issues implicating judgement and imparting issues implicating judgement and imparting

qualityquality

• Diligent and knowledgeable membershipDiligent and knowledgeable membership

Audit Committees Best Practices