Speech by SEC Staff:
Audit Committees: A Call to Action

by Lynn E. Turner

Chief Accountant
U.S. Securities & Exchange Commission

Accounting Irregularities II: What's an Audit Committee To Do?
New York, New York

October 5, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Turner and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Thank you for the kind introduction and opportunity to share with you my thoughts on high quality financial reporting and the role of audit committees in achieving that goal.

Let’s set the stage for our discussion first. This country’s capital markets have fueled the longest economic boom and period of prosperity the United States has ever experienced. Over one third of this country’s wealth is invested in our capital markets that have an aggregate value of 15 trillion dollars, almost twice the Gross National Product. Almost 80 million investors from all walks of life have placed their trust and confidence in the U.S. capital markets. They are unquestionably the most liquid and deep markets in the world.

The markets and their participants have gained investors’ confidence through quality information and their trust through vigilant and active corporate governance. It is quality information that is the life-blood of markets; corporate governance that ensures the flow of that information is not severed.

Yet investors and the business community learned a very valuable lesson 70 years ago--that the trust and confidence in markets can be shaken and lost. We learned that liquidity can disappear and capital quickly dry up. Fair and orderly markets can dissolve much more quickly than they are built. An economy that is seemingly the Emerald City of Oz with roads of gold can turn to a bowl of dust overnight.

Today, we can ensure against such events by building a foundation based on a sound accounting and financial reporting system. And audit committees are uniquely positioned to oversee the construction and operation of those systems. But if the actions and influence of audit committees are to be real, to be more than a façade at the front of a building, then they must extend beyond a playing field defined by prescribed rules, obligations and responsibilities. Instead, the boundaries of an audit committee’s efforts must be shaped by an unwavering commitment to investors and a dedication to the integrity of high quality financial reporting.

The starting point for that commitment should be the five Guiding Principles for Audit Committee Best Practices, included in the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees ("BRC"). I strongly urge each and every Audit Committee that is serious about the quality of the financial reporting of their company to seriously consider these practices.

Principle 1 discusses the Audit Committee’s key role in monitoring the other components parts of the audit. In this pivotal role, aptly described as the first among equals, the committee oversees management who has and must accept the primary responsibility for the financial statements, the external auditors who investors rely on to provide an unbiased, robust examination of the numbers to ensure their credibility and integrity, and where they exist, internal auditors who provide a source of advice and information on the processes and safeguards that exist. It is important that this oversight role be timely, robust, diligent and probing.

Principle 2 states the importance of independent communication and information flow between the audit committee and internal auditor. This is especially important today as the internal auditor can evaluate and report to the audit committees on the adequacy and effectiveness of a company’s internal controls.

In today’s electronic world, the design and operation of effective internal accounting controls is more important than ever. And yet with increasing frequency, as the 1999 Committee of Sponsoring Organizations ("COSO") Report entitled, "Fraudulent Financial Reporting: 1987 - 1997," notes, financial frauds often involve the override of internal controls by a company’s Chief Executive Officer and/or Chief Financial Officer.

Principal 3 of the BRC Report is the need for independent communication and information flow between the audit committee and the outside auditors. The BRC goes on to state "Integral to this reliance is the requirement that the outside auditors perform their service without being affected by economic or other interests that would call into question their objectivity and, accordingly, the reliability of their attestation…the Committee believes that every audit committee should adopt additional voluntary measures to ensure outside auditors objectivity." (emphasis added)

Principle 4 of the BRC Report is one of the cornerstones of the foundation of high quality financial reporting. That principle requires candid discussions with management, the internal auditor, and outside auditors regarding issues implicating judgment and impacting quality. A key word in this paragraph is "candid."

Finally, and equally important to the first four principles, is number 5, Diligent and Knowledgeable Committee Membership. It goes without saying you have to know what you are doing before you can do it, and to do any job right you need the right tools.

Since the issuance of the BRC Report, and the adoption of the new audit committee rules by the stock exchanges, Auditing Standards Board and SEC, I have heard about audit committees that have undertaken with renewed enthusiasm their role in corporate governance. This in turn should contribute to the quality of information the stockholders are receiving.

I would like to share with you some additional thoughts on ways to improve the performance of audit committees that hopefully will improve the quality of the company’s public information and financial reporting.

The COSO Report noted that many financial frauds occurred in companies where audit committees met infrequently. Too often, I have heard of committees that meet maybe just once, two or three times a year, often for a few minutes over breakfast or just before the regular board meetings. Such practices cannot foster the type of in-depth, robust dialogue the BRC called for. Sound advice from the auditors, both internal and outside will be short-changed, if presented at all, and there can be no in-depth probing into the quality of financial reporting done by management.

As a result, I would strongly encourage audit committees to meet no fewer than four times a year. Additional or extended meetings may very well be needed for new committee members in order for management to provide useful training for committee members on the company’s accounting practices and business operations. This basic understanding is fundamental to the ability of audit committee members to be able to adequately fulfill their responsibilities.

Just as the audit committee has responsibilities, so does the external auditor. In the words of the BRC, "It is…imperative to the integrity and effectiveness of the audit committee’s oversight process that all parties recognize that the audit committee and full board, as the representatives of shareholders, are the ultimate entities to which auditors are accountable." As such, the audit committee should review on a regular basis the relationships between management and the internal and external auditors. It is critical that the external audit engagement partner clearly understands that he or she is responsible to and serving the investors and audit committee, not management. It is the audit committee who hires auditors, evaluates their performance and, when necessary, fires them.

It also it the responsibility of the audit committee to ensure the auditors are compensated fairly for performing an effective and quality audit. Over the years, I have been disappointed by audit committees who considered their most important job to be to negotiate the lowest possible fee, without regard for audit quality. It is this type of behavior that leads one quickly down a road filled with ruts and thorny bushes. An audit committee that "brow beats" an auditor into an unrealistically low fee will have to share the blame if at a later date investors call into question the quality of the company’s financial reports.

Instead, audit committees should inquire about issues such as:

1. The adequacy of staffing of the audit.
2. The experience levels of the auditors assigned to the audit, including their experience with the company and its industry.
3. The percentage of the audit hours spent by the more experienced partner and manager.
4. The number of hours spent on the engagement by the partner and manager.
5. The number of hours being spent by the partner and manager on the more judgmental and risky business and financial reporting issues.
6. The adequacy of time spent on areas requiring significant judgment and that have the greatest inherent risk when it comes to the numbers.

In our recent public hearings on the Commission’s auditor independence proposal, one well known audit committee member recommended that audit committees should inquire about and ensure that the audit fee does not represent a "loss leader" being used to leverage the audit into other consulting engagements. He also recommended that audit committees inquire about the compensation scheme for the audit partner and determine if it is affected in any way by the cross selling of consulting services. I strongly endorse these recommendations.

And speaking of some recommendations audit committees should be aware of, the Panel on Audit Effectiveness, commonly referred to as the O’Malley Panel, recently issued their final report. It had two recommendations for audit committees related to auditors’ independence. First, the Panel recommended that audit committees pre-approve non-audit services that exceed a threshold set by the committee. Our public hearings confirmed that many companies already follow this best practice.

The O’Malley Panel went on to recommend that in determining the appropriateness of a service, an audit committee should consider ten factors as follows:

1. Whether the service is being performed principally for the audit committee.
2. The effects of the service, if any, on audit effectiveness or on the quality and timeliness of the entity’s financial reporting process.
3. Whether the service would be performed by specialists (e.g., technology specialists) who ordinarily also provide recurring audit support.
4. Whether the service would be performed by audit personnel, and if so, whether it will enhance their knowledge of the entity’s business and operations.
5. Whether the role of those performing the service would be inconsistent with the auditors’ role (e.g., a role where neutrality, impartiality and auditor skepticism are likely to be subverted).
6. Whether the audit firm personnel would be assuming a management role or creating a mutual or conflicting interest with management.
7. Whether the auditors, in effect, would be "auditing their own numbers."
8. Whether the project must be started and completed very quickly.
9. Whether the audit firm has unique expertise in the service.
10. The size of the fee(s) for the non-audit service(s).

I believe the Panel, which included respected corporate board members and representatives of the legal profession, developed an outstanding list of factors. I urge each and every audit committee to seriously consider these factors as they determine if it is appropriate to approve a specific non audit service provided by the independent auditor.

The AICPA has also issued two important new standards affecting audit committees and auditors. The two new standards are, Statement on Auditing Standards ("SAS") No. 89 on Audit Adjustments and SAS No. 90 on Audit Committee Communications. The AICPA's SAS 90 requires the auditor to discuss with the audit committee the QUALITY, not just the acceptability, of the accounting principles used by an entity. This Quality discussion should include not only the audit committee and the auditor, but also management, since management has primary responsibility for the entity's financial reporting. The Quality discussion should be robust, candid and probing and encompass:

1. Consistency of the entity's accounting policies and their application,
2. The consistency, clarity and completeness of the financial statements and related disclosures, and
3. Items having a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information.

Warren Buffet, perhaps the most widely recognized investor of our time, also weighed in during the development of the Blue Ribbon Committee's recommendations. He suggested an approach based on audit committees asking auditors three intriguing questions:

1. If the auditor were solely responsible for preparation of the company's financial statements, would they have been prepared in any way different than the manner selected by management? The audit committee should inquire as to both material and nonmaterial differences. If the auditor would have done anything differently than management, an explanation should be made of management's argument and the auditor's response.
2. If the auditor were an investor, would he have received the information essential to a proper understanding of the company's financial performance during the reporting period?
3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?

The answers to these questions really indicate whether, if the auditor was running the Company, the same financial statements and disclosures, would have been published and the same internal controls would have been established. Perhaps that’s why Warren Buffet recommended that the audit committee document the response to these questions in its minutes.

I have seen a publication by Arthur Andersen, which takes the audit committee and management through the discussion on quality. This publication, "New Responsibilities and Requirements for Audit Committees," is an exceptional publication and lists sample questions to guide the discussion. Here are some sample questions that are in their book.

Relevance/Predictive Value/Earnings Persistence

• When identifying unusual or nonrecurring items for disclosure, are both gains and losses given equal importance?
• To what extent was the timing of transactions managed in order to occur (or not occur) in the reported period? What was the purpose of managing the timing? How did that affect the predictive value of the reported results?

• What specific aspects of the company's disaggregated information, taken as a whole, lead you to believe that the company has communicated a sufficiently complete understanding of its various business opportunities and risks?
• How does the discussion of the company's business segments in MD&A and other non-financial statement reports (including discussions with analysts or reporters) complement the segment information presented in the financial statements? What specific examples illustrate how the respective disclosures complement each other?
• What specific examples illustrate how the respective disclosures complement each other?

• How much information is provided about management's previous expectations, results that confirm such previous expectations, and reasons for expectations not being met?
• Do the reported results (including the company's financial position) provide feedback to investors as to how various market events and significant transactions affect the company?

• In what way does the company go beyond merely complying with SEC filing requirements in terms of timeliness?
• What new ways of communicating financial information (e.g., internet communications, etc.) has the company used or begun to consider?
• How does the company ensure that it provides the same information to all interested users at the same time?

• What are the most judgmental aspects of the company's financial reporting from a measurement perspective? How does the information in the financial statements allow a reader to understand what those aspects are?
• What information in the financial statements (and MD&A) communicates the significant estimates and assumptions used to develop financial information? Where there is a range of possible outcomes, how does the company communicate that range to investors?
• How does the company assess whether its significant estimates and assumptions are based on the best information available? Does the company use independent specialists or sophisticated quantitative techniques to validate or develop key estimates and assumptions?
• What materiality thresholds does the company use for recording transactions and preparing its financial statements? How are these thresholds communicated to accounting, sales, purchasing and other appropriate personnel?

Reliability/Completeness

• What are the most significant events of the past year and how are those communicated to investors? Is the information presented in an even-handed manner?
• How are both negative and positive events presented in the financial statements and MD&A? What process did management follow to ensure the story was told fairly and impartially? Is the weight placed on these events appropriately balanced with other events?

Reliability/Substance/"Representational Faithfulness"

• How does the company assess whether the accounting principles it has selected will appropriately convey the underlying economics of the transactions? What accounting principles changed during the year and how were they assessed?
• When the company enters into significant or complex transactions for which the accounting literature is not black and white, how does the company assess whether its accounting is appropriate?
• To what extent does the company enter into (or modify) transactions in order to achieve a specific accounting result? In those situations, how does management ensure that the accounting is an honest and clear portrayal of the substance and purpose of the transaction?
• To the extent that the accounting literature precludes the company from portraying the transaction according to its substance, what information does the company provide (in the footnotes and the MD&A) to supplement the investor's understanding?

Reliability/Neutrality

• Looking at significant judgments made, how neutral was management's assessment of the likely outcome? What specific examples illustrate this?
• Although characteristics such as "aggressiveness" or "conservatism" mean different things to different people, one way or another, they suggest some type of bias. Thinking about those two terms, how close to "neutral" is the company's accounting for and disclosure of significant events and transactions?
• How does neutrality factor into management's selection of accounting principles? Will the selected accounting principles present a balanced view?

• What changes, if any, have there been in the company's accounting policies or in management's application of the policies and the use of estimates and judgments? In what way are those changes an improvement over past practices? What specific disclosures can you point to, to demonstrate that the effect of the changes on all periods has been appropriately disclosed?
• What indication, if any, is there that changes in the company's accounting policies, in the application of those policies, or in the use of estimates and judgments are motivated by management's desire to achieve a specific accounting result?

• In what way do the company's disclosures go beyond complying with the absolute minimum requirements of GAAP?
• How well organized and easy to follow is the company's presentation of its information?
• Is the language used in the financial reports easily understandable by non-accountants? How has the company applied "plain English" concepts to its financial information?
• How has the company made use, in its financial reports, of simple, clear graphs and charts to enhance the understandability of the financial information?
• Do the financial statements and other disclosures (e.g., MD&A) form a comprehensive, cohesive, and coherent set of financial information that "tell the whole story"?

In addition to the use of these or similar questions, I suggest companies and their audit committees should develop their own Report Card as a specific scoring mechanism using the above categories, to more fully assess the quality of their financial reporting.

I also encourage audit committees to ask questions about the quality of the company’s public earnings releases. Too often today, we are seeing press releases that convey an incomplete or inaccurate picture to investors. I call it an "EBS" or "Everything but Bad Stuff" release. For example, I have seen releases that present:

1. Earnings before marketing costs,
2. Cash earnings per share that bear no relevance to cash flows but rather are merely earnings adjusted to eliminate amortization of selected costs,
3. Earnings before losses from newly started up businesses, such as a new internet subsidiary, or
4. Any one or combination of the above, but with one time gains from sales of investments added back.

Hopefully, audit committees will view with skepticism this unbalanced approach to disclosure of financial information. In the meantime, I will encourage investors to read such earnings releases with a wary eye and encourage them to read the full Form 10-Q where all the facts should be presented in a complete and balanced fashion.

Finally, let me encourage all audit committees to undergo an annual evaluation. Just as the board of directors evaluates the management team, I believe the audit committee should perform an annual self-assessment of its performance and obtain input from the entire board of directors as well. Input from the external auditors who have the invaluable perspective of working with many audit committees may also be very useful and a source of best practices. The external auditor may also be able to assist the audit committee in designing a self-assessment program.

Let me close by again noting the great work that members of the accounting profession, the Blue Ribbon and O’Malley Panels, and the stock exchanges have performed. These efforts have all made the tremendous progress to date possible, and an improvement in the quality of financial reporting hopefully inevitable. To achieve those improvements will not be an easy task, but I have every faith we can get there, a faith that I hope the work of audit committees will sustain.

Thank you.

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