Recent events surrounding the bankruptcy of Enron Corp. and $3.8 billion in accounting irregularities at WorldCom, Inc. have highlighted the importance of audit committees. This article considers the nature and scope of the responsibilities of a company’s audit committee. In the current environment, it is important for all board members, and members of audit committees in particular, to take the time to carefully examine the appropriate role of the audit committee. Past practices should be evaluated and consideration should be given to whether greater activity or any change in emphasis is required.

A related article, which appeared in the Spring 2002 issue, addressed independence requirements and disclosures that must be made by public companies concerning their auditors and audit committees. That article identified some of the requirements that apply to audit committees under rules of the Securities and Exchange Commission (“SEC”) and for some companies under the rules of NASDAQ, the New York Stock Exchange and the American Stock Exchange. For example, companies having securities quoted on NASDAQ or listed on the exchanges are generally required to have audit committees consisting of at least 3 members who meet certain financial literacy and independence criteria and to adopt audit committee charters. The SEC rules apply more generally to public companies and require that certain disclosures be made to stockholders confirming that the audit committee reviewed certain documents, held certain discussions and recommended use of the company’s audited financial statements.

The rules applicable to audit committees clearly encourage members of audit committees to be informed, vigilant and effective in discharging their responsibilities, but they do not provide detailed guidance concerning the procedures that should be followed by audit committees. Therefore, there is a need to consider in detail how audit committees should function. Some of the issues involved concern organizational matters, such as whether an audit committee charter should be voluntarily adopted if one is not required by applicable rules, how often the audit committee should meet, what time commitment should be expected from members of the audit committee, whether the audit committee should be assigned responsibility for matters in addition to oversight of the audit function, and what matters should be included on the agenda of meetings of the audit committee. Other issues relate to the nature and scope of the inquiries that should be made by the audit committee relating to the audit and the performance of non-audit services.

Organizational Issues. Companies that are not required by applicable rules to adopt a charter for their audit committees by those companies should seriously consider doing so voluntarily. Adoption of such a charter provides an important opportunity to clearly define responsibilities and expectations.

The number of meetings and the necessary time commitment will vary depending on the complexity of company’s business and its financial situation. The audit committee may wish to establish a calendar and schedule meetings with a view to significant corporate filing deadlines. Quarterly meetings could permit the audit committee to conduct an advance review of quarterly filings with the SEC. Another possible approach would be to assign a member of the audit committee to meet with management to discuss such quarterly filings before they are made and to report the results of such discussions at the next meeting of the audit committee.

The audit committee normally should not be required to perform difficult and time-consuming activities that are unrelated to its oversight of the audit function. If such activities need to be performed, it is usually better to assign them to a different committee. It is important, however, for members of the audit committee to have an adequate understanding of important corporate matters that are not directly related to the audit function. Occasional presentations to the audit committee concerning particular aspects of the operation of the company may be useful. In some cases it may be advantageous to have one of the members of the audit committee serve on another key committee or at least attend the meetings of that committee.

The audit committee should establish its own agenda. Items that should be considered for inclusion on the agenda include the following:

• Review of management letter comments.
• Review of the Independence Standards Board letter provided by the outside auditor.
• Discussions with management to review the company’s audited financial statements, the quality and acceptability of the company’s financial reporting and controls, the nature and extent of non-audit services to be performed by the outside auditor, and related matters.
• Discussions with outside auditor concerning their fees, their independence and their non-audit services.
• Discussions with internal and outside auditors concerning the results of their audits, their evaluations of the company’s internal controls, and the overall quality of the company’s financial reporting.
• Preparation or review of the report of the audit committee.
• Review of filings made with the SEC
• Review of press releases issued by the company
• Review of litigation exposure
• Risk identification and risk management
• Review of management transactions involving potential conflicts of interest

Audit Committee Inquiries. In order to function effectively and promote accountability , an audit committee should actively interact with management and with internal and external auditors. An audit committee should exercise a certain degree of healthy skepticism about the information it receives and be prepared to offer constructive criticism. To make the best use of the limited time available to the audit committee, an effort should be made to identify critical accounting policies, which will vary from one company to another. Critical accounting policies are those that have a material effect on the company’s financial statements and that involve significant judgments on the part of management.

A number of commentators have made helpful suggestions concerning inquiries that are likely to be productive in this context. Some of these suggested inquiries are listed below:

• If the auditor were solely responsible for the preparation of the company’s financial statements, would they have been prepared differently, and if so how and why?
• If the auditor were an investor, would he consider that the company’s financial statements provided the information essential to a proper understanding of the company’s financial performance, and if not why not?
• Is the company following internal audit procedures that the auditor would follow if he were managing the company, and if not, what are the differences?
• What accounting issues relating to the audit presented the greatest difficulty?
• What accounting issues were the subject of the most discussion with management?
• What judgments, estimates or timing decisions made by management had the greatest effect on the company’s financial statements?
• Were non-standard adjustments made that were individually or in the aggregate material?
• Were accounting principles applied aggressively or conservatively?
• Were there material changes in accounting principles from the prior year?

Consideration should be given to establishing a policy requiring prior audit committee approval of non-audit services for which fees will exceed a threshold determined by the audit committee. With respect to the performance by the outside auditor of non-audit services, the SEC has recommended that inquiries be made concerning the following matters:

• whether the service is being performed principally for the audit committee;
• the effects of the service, if any, on audit effectiveness or on the quality and timeliness of the Company’s financial reporting process;
• whether the service would be performed by specialists who ordinarily also provide recurring audit support
• whether the service would be performed by audit personnel and, if so, whether it would enhance their knowledge of the Company’s business and operations;
• whether the role of those performing the service (such as a role where neutrality, impartiality and auditor skepticism are likely to be subverted) would be inconsistent with the auditor’s role;
• whether the audit firm’s personnel would be assuming a management role or creating a mutuality of interest with management;
• whether the auditors, in effect, would be auditing their own numbers;
• whether the project must be started and completed very quickly;
• whether the audit firm has unique expertise in the service; and
• the size of the fee(s) for the non-audit services.