RSM Resources

In the post-Sarbanes-Oxley business world, audit committees in public companies are under more pressure to understand not just a company’s financial intricacies, but to challenge management and auditors on key accounting, internal control and compliance issues.

According to a national expert who has assembled a series of tools to improve audit committee effectiveness, many companies still struggle with how to unlock the potential of this critical role. A good place to start is the audit committee’s charter.

"Over the last couple of years, we talked with a lot of audit committee people about what they were doing about written charters, which are now required for exchange-traded companies," says John Morrow, vice president of the American Institute of Certified Public Accountants (AICPA). "Most of them said they might look at it once a year,but that most of the time it just sat on the shelf. That’s a lost opportunity to make the charter actionable, by using it as a tool to help guide the audit committee’s agenda and effectiveness."

In the wake of financial scandals that caused firms like Enron and WorldCom to implode, audit committees have risen from relative obscurity to center stage in modern corporate governance. In its new role, the typical audit committee is charged with a wide range of duties, including:

• Hiring and monitoring the services and independence of an outside audit provider.
• Overseeing a company’s financial reporting and evaluating its outside and internal audit processes.
• Reviewing quarterly and year-end financial statements and related Form 10-Q or 10-K disclosures.
• Implementing whistle-blower procedures to handle complaints in internal accounting, auditing or financial reporting matters.
• Helping the board of directors oversee compliance with legal and regulatory matters.

Because of the role’s increased complexity and accountability, Morrow said it’s easy for directors of small to midsized public companies to feel overwhelmed when considering changes or improvements. With that in mind, the charter provides a good starting point to establish,implement and measure audit committee objectives. As a bonus, a well-designed charter serves as strong evidence that directors are serious about meeting their obligations under the SOX legislation.

"If an audit committee has been thoughtful about defining its charter, and outlining the when, how and why on its deliverables, that’s a pretty good indicator that they’re on a good path in regard to oversight of internal controls," says Morrow.

Another critical issue influencing audit committee effectiveness, experts say, is the financial savvy of members. In recent years,the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and National Association of Securities Dealers (NASD) have added "financial literacy" requirements for firms trading on these exchanges. More recently, SOX required public companies to add an "audit committee financial expert."

University of Chicago business professor Roman Weil, a noted authority on the role of audit committees and corporate governance, told attendees of the 2005 National Directors Institute meeting that potential recruits to an audit committee should be scored on a four-point scale. The most weight, he says, should be accorded to prospects with strong financial accounting backgrounds, such as current or former CPAs and CFOs.

Weil’s approach offers an additional benefit:stronger financial returns. In a study of Fortune 1000 companies between 2000and 2004, he found companies that stocked their audit committees with financial accounting experts delivered stock market returns an average of 4.6 percent higher than peer businesses that did not take that step.

Those findings did not surprise Morrow.

"Clearly, audit committee members today need to have a much more detailed understanding of business, industry trends and issues surrounding financial accounting practices," he says. "It can no longer be a role where members just accept everything management says."

With a strong charter and financial experts in place, audit committees can improve their odds for success by staying focused on core governance issues. In a 2002 speech on audit committee effectiveness,Robert Herdman, former chief accountant of the Securities and Exchange Commission (SEC), suggested that directors hone in on three key points,including:

• Controlling the agenda. In this area, Herdman says audit committees should be more assertive in leading — not reacting — to issues of auditor independence, scope and fees, and internal controls. He adds that the committee should champion a company’s code of conduct and settle for nothing less than direct, independent access to top managerial, internal audit, and external audit personnel.
• Conducting due diligence. An effective audit committee, Herdman says, cannot be afraid to challenge management assumptions or to seek frank assessments on a company’s financial competence. A good place to do the latter, according to AICPA’s Morrow, is in executive session — where minutes are not taken and participation is limited to a company’s financial management and the audit committee. "This is the place to ask tough, insightful, direct questions and listen to what is and is not being said," he notes. "If members are adept at asking open-ended questions, or posing the same questions to different people, you can use this type of meeting to gather a huge amount of knowledge about what is going on in an organization."
• Taking time to understand. Even a highly qualified committee of financial professionals can benefit from time to digest complex accounting data or seek informed opinions from outside experts. Herdman says an effective audit committee will do annual work plans that include pre- and post-meeting work assignments to ensure members are well-prepared for each regular scheduled session. The work plans can also include key self-assessment dates, which allow the committee to track its progress against goals in the charter.

By taking these steps, your board’s audit committee can strengthen its ability to challenge and improve financial management in your company.