The most effective impetus for broad change in corporate governance is usually specific scandal or fraud. The UK’s Cadbury Committee is a case in point. Convened to look into specific accounting irregularities, it found cause to broaden its recommendations. It should come as no surprise then, that after a rash of questionable auditing practices in the US (Cendant, Bankers Trust, Sunbeam, etc) regulators and exchanges are taking a hard look both at specific cases and also at the overall process for reform.
In a now historic speech in September 1998 in New York, SEC chairman Arthur Levitt declared war on several types of questionable accounting practices, such as managing earnings; improperly recognizing revenues; taking unjustified restructuring and M&A charges; and setting up ‘cookie-jar reserves.’
In response, the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees was convened and its recommendations were aired in February. Ira Millstein, co-chair of the committee, recently walked a Conference Board group through the genesis of the debate and the committee’s recommendations. They fall into two main categories: listing changes proposed for the exchanges; and disclosure requirements for adoption by the SEC. The listing changes are moving along but the disclosure recommendations face significant opposition.
Listing Requirements.
Recommendations relating to the independence of audit committee members, their number and qualifications, and their requirement to adopt a formal charter, are moving through both NASD and NYSE board approval.
Only minor changes are likely. One was flagged by the NYSE itself, in a June letter to listed company CEOs asking for comment. The NYSE proposed to remove the $200 mn capitalization cut-off and impose the requirements on smaller companies, presumably because most of the auditing fraud (by numbers of companies if not by dollar amount) is carried on by smaller companies. To facilitate implementation of the new standards, the NYSE also suggested an appropriate transition period. The NYSE proposes to grandfather all currently qualified audit committee members until they are re-elected or replaced. It also intends to grant listed companies with only one or two members 18 months to recruit additions.
According to the new listing requirements: ‘Members of the audit committee shall be considered independent if they have no relationship to the corporation that may interfere with the exercise of their independence.’ Several types of relationships are specifically spelled out which would disqualify a director from serving on an audit committee:
- employment by the corporation currently or for the past three years.
- accepting compensation from the listed company except for board service or benefits under a tax-qualified retirement plan.
- being an immediate family member of a person who is or has been in the past three years an executive officer of the listed company or any of its affiliates.
- being a partner, controlling shareholder or executive of an organization to which the listed company has made or received significant payments during past years.
- being an executive of a company if any executive of the listed company sits on the compensation committee of such other company.
Disclosure Requirements.
The most controversial Blue Ribbon recommendations relate to ‘disclosure requirements’ which would follow the proposed SEC regulations. Recommendations viii and ix relate to the term ‘quality’, which appears to some to be too vague. Others don’t like the sense of recommendation ix, which seems to put the audit committee members at risk of higher liability and, some argue, to duplicate the auditor’s functions.
The Business Roundtable is one of the fiercest critics of the Blue Ribbon Committee’s recommendations which, it feels, go against the current monitoring rather than managerial trend in corporate governance. Although, it says, all audit committees share certain functional characteristics, companies should be allowed a degree of flexibility.
A forthcoming report Determining the Effectiveness of the Board of Directors, by Lucy Alexander of The Conference Board, spells out that many corporate executives believe the audit committee’s primary responsibility to be oversight. It is management’s job to put together accurate accounting systems and prepare the financial statements; then the outside auditors assess whether the figures fairly represent how well the company is doing. The audit committee is responsible for making sure both parties do their job properly. This involves:
- reviewing the internal and external auditors’ risk assessment and overall audit plans;
- reviewing the company’s risk management, financial reporting and disclosure policies and its system of internal controls; and
- reviewing the performance and effectiveness of the internal and external auditors.
In an age where accounting firms are providing lucrative consulting services as well as less lucrative auditing services, taking special care to ensure auditor independence is critical. And, when the SEC is working with state attorneys-general to prosecute corporate executives and seek jail time for audit fraud, it’s worth paying special attention to curb abuses.
Dr Carolyn Kay Brancato is head of the Conference Board’s Global Corporate Governance Center
