Five Strategies Audit Committees
Can Employ to Rebuild Public Trust and
Confidence in Financial Reporting
Barry Jay Epstein, Ph.D., CPA and Elaine Vullmahn, CPA, CIA
The epidemic of management frauds, and of auditors’ failures to prevent or detect those frauds, has been widely reported over the past decade. Relatively less attention has been directed at the role of audit committees, and their failures, concerning these debacles. Public (investors’ and creditors’) confidence in the integrity of the financial reporting process has been harmed, with serious consequences that include increased cost of capital for many companies, even those untouched by scandal.
Audit committees can play a crucial role in repairing this damage. While this most recent cycle of financial reporting scandals has already caused further attention to be given to the issue of corporate governance – which led to passage of Sarbanes-Oxley and other structural reforms – actual implementation of meaningful changes arguably has lagged. More needs to be done to restore full confidence in our private enterprise system.
If optimally configured and resourced, audit committees serve as a key bulwark for ensuring the integrity of the financial reporting process. They should, and likely will, be subjected to continuing scrutiny and held to higher performance expectations by investors and regulators. A comprehensive program that includes the following five elements will provide boards of directors and their audit committee members with the tools they need to appropriately discharge their duties.
Assess Financial Reporting Quality
A formal assessment of the quality of the company’s financial reporting should be conducted. This would enable audit committee members to gauge the company’s financial reporting performance against entity-specific benchmarks, which could prove important in managing investor expectations.
The following attributes are generally acknowledged as being important to the quality of information, but have rarely been implemented as value-drivers. This is principally because of their qualitative nature, making the process of measurement challenging. But by employing non-metric scaling and other techniques, the relative extent to which ‘trade offs’ among these attributes are condoned can be determined. The key determinants of the company’s reporting quality that should be diagnosed include:
- Relevance: Information is useful and provided in a timely manner thereby allowing the user to make informed and fact-based decisions. The constituent aspects of relevance are: a) timeliness – information is available to the user before it becomes irrelevant to decision-making; and b) predictive value – information permits the user to evaluate the likely levels of recurring earnings and assess opportunities and risks within individual business units or geographic areas.
- Reliability: Information is a verifiable and faithful representation of transactions and events. The components of reliability are: a) measurability – information permits reasonably consistent interpretation by knowledgeable third parties; and b) completeness –information identifies and presents all aspects of events and transactions that could alter the users’ conclusions.
- Neutrality: Information is free from bias.
- Comparability: Information is prepared and presented in a manner that allows informed comparison to other periods of time and to other companies.
- Understandability: The information is presented in an organized and coherent fashion without jargon or boilerplate language.
Evaluate Processes for Reviewing Financial Information
Audit committees should have an evaluation performed of the company’s and board’s processes for reviewing financial information. Audit committee members need to become aware of weak reporting or disclosure practices that could needlessly impair the company’s reputation for forthright behavior and financial reporting. Particularly under current market conditions, when transparency in financial reporting is highly prized, an educated and empowered audit committee can help effectuate quality financial reporting so that, when there are no substantive issues to tarnish the company's reputation, the risk of unfair criticisms can be avoided.
This evaluation should suggest ways in which the entity can improve their internal processes so that real or apparent problems can be avoided. Matters such as the timing and extent of the pre-issuance review of press releases, materials for investor briefings, annual and interim financial statements, 8-Ks, and statutory filings should be examined. Armed with these findings, the audit committee will be better able to judge the magnitude of risks arising from disclosure matters and the company’s history and experience regarding accuracy and completeness of financial reports.
Conduct a Peer Group Comparison
Audit committees should arrange for periodic comparisons of financial reporting quality performed among the entity and its industry peers. Audit committee members’ ability to meaningfully question management and outside accountants is heavily reliant upon access to valid, current information about changes in key financial statement indicators and practices. This information is enhanced in utility when placed in the context of analogous data from industry peers and other relevant entities.
Committee members would greatly benefit from insights regarding matters such as relationships between financial statement items that have, e.g., changed either suddenly or over time; that differ significantly from those of the company’s peers; or that exist or are absent contrary to expectations. Taken together, these may be indicia of matters such as declining liquidity, increasing leverage, or inadequate cash flow. They may also suggest that overly aggressive (or, alternatively, overly conservative) accounting principles have been adopted, distorting comparisons with peer companies and possibly implying deliberate, inappropriate actions by financial management of the company. Audit committee members should be able to identify these issues and, where appropriate, question both the underlying management decisions that may have contributed to the situation, and more importantly, the reporting and disclosures for these matters. Having expert assistance will facilitate making these determinations.
Obtain Industry Specific Training
Audit committees should obtain tailored, industry-specific training on financial reporting matters. This would enable audit committee members to enhance their understanding of appropriate reporting policies and practices of their company and others in its industry. The ability to ask penetrating questions about accounting and financial reporting matters and to evaluate answers received is critical to discharging the committee’s fiduciary duties.
Being trained would enable audit committee members to develop the self-assurance needed to challenge management and outside auditor decisions on accounting and reporting choices they have made, as they must do. Other, periodic training sessions would assist committee members in staying abreast of current developments in accounting and corporate finance that could affect the company’s operations and financial reporting.
Consult With An Independent Accounting and Auditing Advisor
Audit committees should consult with an independent accounting advisor. They have the right, under Sarbanes-Oxley, to obtain both legal and financial reporting assistance, to be compensated by the reporting entity. Exercise of this right can vastly improve their ability to fulfill their fiduciary responsibilities. An accounting advisor would be of significant value, in terms of both appearance and substance, in rebuilding public trust and confidence in the integrity of financial reporting systems and processes.
Audit committees are advised to seek assistance on matters of: (1) their financial literacy and the financial expertise requirements under the rules of the exchanges and the Sarbanes-Oxley Act; (2) the content of the audit committee report presented in the annual proxy statement, addressing the committee’s findings from execution of its financial reporting oversight responsibilities; and (3) the audit committee’s discussions with the independent auditors regarding the auditors’ judgments on the qualitative characteristics of financial reporting and accounting information.
In conclusion, a comprehensive audit committee consultation program can do much to enhance the perceived quality of the company’s financial reporting, the processes used to ensure transparency and veracity, and the company’s commitment to full disclosure and conservative financial accounting.
Note: This article was first published on Law.360 on June 30, 2010.
About the Authors: Barry Jay Epstein, Ph.D., CPA, (email) is a litigation director in the Chicago office of SS&G Financial Services, Inc., where his practice is concentrated on technical consultations on GAAP and IFRS, and as a consulting and testifying expert on civil and white collar criminal litigation matters. Dr. Epstein is the co-author of Wiley GAAP 2010, Wiley IFRS 2010, Wiley IFRS Policies and Procedures, and other books. At the time of this writing Elaine Vullmahn, MBA, CPA, CIA was a Senior Litigation Accountant with Russell Novak & Company, LLP, specializing in internal control matters and litigation consulting. Ms. Vullmahn received her J.D. at the John Marshall Law School, class of 2011.