Advancing the Role and Effectiveness of Audit Committees
The Securities and Exchange Commission (“SEC” or “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 the author and do not necessarily reflect the views of the Commission, individual Commissioners, or of the author’s colleagues upon the staff of the Commission.
Good afternoon and thank you Dr. Terry Neel for the kind introduction. I want to also acknowledge and thank Dr. Joseph V. Carcello, as the Accounting and Information Management Department Head and the cofounder and Executive Director of the Corporate Governance Center for his invitation to speak here today.
Before I begin, let me remind you that the views expressed today are my own and not necessarily those of the Commission, the individual Commissioners, or other colleagues on the Commission staff. Let me also express a word of gratitude to the entire OCA team for their work in providing advice to the Commission regarding accounting and auditing matters arising in the administration of the federal securities laws. I want to also acknowledge their valuable assistance in preparing me to make today’s remarks, including Emily Fitts, Karen Plunkett, Ying Compton and Duc Dang. Also, Jenifer Minke-Girard has recently taken on the role of Interim Deputy Chief Accountant – International as she continues to serve as the Vice Chair of IOSCO’s Committee on Issuer Accounting, Audit and Disclosure, which is known as Committee 1. In her role, Jenifer will oversee the activities of the Office of the Chief Accountant’s International Group, which include collaborating with securities regulators from other countries on proposals and requests from international accounting, audit, and ethics standard setters, interpretative committees and oversight bodies. Having recently “timed out” of her role as Chair of Committee 1 after almost 10 years of outstanding leadership, Julie Erhardt continues to serve as a Deputy Chief Accountant, taking on roles that include leading our work to identify and assess the impact of emerging trends and events on accounting and auditing matters.
The livelihood of every American depends in a meaningful way on how well accountants do their jobs. Economic decisions are no better than the information on which they are based — if the numbers are wrong, the decisions are wrong, and our economic future is placed at risk. Investors depend on accurate financial reporting.
Financial reporting can and should provide investors with a clear picture of a company’s financial condition – information that investors need to make informed investment decisions as they place their investment capital with the businesses that need it to operate, grow, and compete. The credibility of financial statements most likely has a direct effect on the price that investors are willing to pay for a company’s securities.
Audit committees also play a critical role in contributing to financial statement credibility through their oversight and resulting impact on the integrity of a company’s culture and internal control over financial reporting (“ICFR”), the quality of financial reporting, and the quality of audits performed on behalf of investors. The importance of the audit committees’ work cannot be overstated.
Broadly, a corporate board is in place to ensure that management is working in the best interests of the corporation and its shareholders — by working to enhance corporate value.
A key element of board oversight is working with management to achieve high quality financial reporting, including implementing quality accounting policies and ICFR and appointing independent external auditors to promote accurate and timely disclosure of financial information to the board, to investors and the public markets more broadly.
This oversight function is typically delegated by the full board to the audit committee. While the listing standards of the primary U.S. securities exchanges mandate that companies have an audit committee, these listing standards leave room for judgement on certain matters as to how an audit committee should be comprised and, moreover, how it should function.
So, today, I would like to talk about ways to reinforce audit committee effectiveness for high quality financial reporting.
The role of the audit committee
The Commission has a long tradition of recognizing the importance of governance and thus promoting effective audit committee oversight. The need to provide markets and investors with more reliable information laid the foundation for the creation of the Commission in 1934 and its mission which continues to this day.
Since as early as the 1940s, the Commission, along with the auditing and corporate communities, has had a continued interest in the ability of audit committees to promote reliability in financial reporting. Over the following decades, there has been an evolution in the role and responsibilities of audit committees. The process was driven by the need to find the appropriate balance between the roles of management, independent auditors and audit committees to achieve the ultimate objective of providing investors with high-quality decision useful information regarding public companies.
In the late 1990s, the NYSE and the NASD, among others, revised their listing standards relating to audit committees, addressing recommendations of a Blue Ribbon Committee formed in response to corporate and governance failures. The Blue Ribbon Committee’s report stated that the “audit committee must be first among equals in this [financial reporting] process, since the audit committee is an extension of the full board and hence the ultimate monitor of the process.”
Many of the Blue Ribbon Committee’s recommendations for strengthening the role of audit committees were subsequently incorporated into listing standards, rules and regulations of the SEC, and the Sarbanes-Oxley Act of 2002, which provided for:
- Enhancements to the role of the audit committee;
- Increased visibility of the audit committee and its responsibilities to investors and other stakeholders;
- Strengthening the relationship between the audit committee (as a representative of investors) and the independent auditors; and
- Enhancements to audit committee independence.
The academic literature has long documented the importance of the independence and expertise of audit committees. For example, studies using data prior to the Sarbanes-Oxley Act of 2002 found better internal control, financial reporting quality, and audit quality for companies with more independent audit committees.  More recently, academic studies further emphasized the vital role audit committees have in the oversight of the independent auditor, audits, and financial reporting.
Fulfilling its oversight responsibilities places the audit committee at the center of the relationship between management of a public company and its independent auditor. Investors look to audit committees with high expectations to establish and maintain the appropriate tone, capacity, and competence to oversee the quality of the financial reporting system.
Understanding the business operating environment
Audit committees should understand the businesses they serve and the impact of the operating environment – the economic, technological, and societal changes – on corporate strategies. Obtaining such an understanding of the entity and its environment is an essential aspect of serving in an audit committee role to oversee and counsel those having responsibility for preparing the financial statements, as well as overseeing the external audit of the financial statement
This understanding establishes a frame of reference in which the audit committee considers the scope of its charter, its agendas, education needs, advisory needs, and ultimately the exercise of its business judgment in assessing the information about the accounting and financial reporting.
As a continuous, dynamic process of gathering, updating, and analyzing information throughout any given year, this understanding also enables the audit committee to consider areas where special consideration may be necessary, for example, related-party transactions, use of the going concern assumption in preparing the financial statements, complex or unusual transactions, evaluating the business purpose of transactions or understanding changes in accounting standards.
The current business operating environment highlights a number of considerations for those involved in financial reporting, including audit committees. For example,
- Operating environment. Changes in the operating environment can result in changes in competitive pressures and different financial reporting risks.
- Rapid growth. Significant and rapid expansion of operations can strain controls and increase the risk of a breakdown in controls.
- New business models, products, or activities. Entering into industries, business areas or transactions with which an entity has little experience may introduce new risks associated with financial reporting, including ICFR. For example, within many industries, some companies will need to understand the impact on financial reporting of the pace and scope of business and competitive changes as they expand from product companies to data and technology services businesses.
- New accounting pronouncements. The implementation of new GAAP standards may affect risks in preparing financial statements, particularly if implementation planning or execution is lacking.
Effectiveness of Audit Committees
Continuing on the topic of audit committee effectiveness, the board (including the audit committee), management (including the internal audit function), and the external auditor all have a distinct role in financial reporting.
Yet, all three together effectuate a system that supports credible financial reporting. In the system, management is responsible for the preparation of the financial statements and for establishing and maintaining adequate ICFR as well as evaluating the effectiveness of ICFR. The external auditor is responsible for opining on the fair presentation of the financial statements and, when applicable, evaluating the effectiveness of ICFR. Last, the audit committee, as the delegate of the full board, is responsible for overseeing the entire process.
One size doesn’t fit all when it comes to audit committees. Within broad parameters, each audit committee develops its charter and agenda. The committee’s job is one of oversight and monitoring, and in carrying out this job, it acts in reliance on senior management, the external auditor, and any advisors that the committee might engage.
Recently, there has been an appropriately strong interest and focus of investors on diversity of thoughts within the board of directors. Investors have expressed that board composition, including diversity, and assessment should be a board priority in the coming year.
Diversity of thoughts diminishes the extent of group thinking, and diversity of relevant skills (for example, industry or financial reporting expertise) enhances the audit committee’s ability to monitor financial reporting. Academic research tells us that boards with diverse members allocate more effort to monitoring, have better financial reporting quality, and are more likely to hold management accountable after poor performance. Given the importance of diversity to audit committee effectiveness, there is an opportunity to increase the level of diversity on U.S. boards and audit committees.
Let me now turn to audit committee capacity and assessment of the workload. Balancing audit committee workload is especially critical given the need for audit committees to stay current on emerging issues, whether financial, ICFR, or disclosure related through continuing education and other means.
Periodic examination of the audit committee’s capacity, which supports any committee’s ability to perform its responsibilities effectively, is necessary.
Recent surveys indicate that some audit committees are finding it difficult to perform its core responsibilities while covering other major risks on its agenda. For example, a recent Corporate Directors survey by an audit firm suggests that while 75% of Board directors say their workload is manageable, only 57% of audit committee members say their workload is manageable.
Among audit committee members, the survey results are more pronounced in certain industries. For example, in the banking and capital markets sector, only 34% of audit committee members surveyed indicated they believe their workload is manageable.
This emphasizes the importance of the role of the board in driving the audit committee’s focus and responsibilities. Board directors should ask themselves if they are identifying the risk of audit committee overload, and if so, are they appropriately managing this risk to enable the audit committee to operate effectively.
While audit committees may be equipped to play a role in overseeing risks that extend beyond financial reporting, such as cybersecurity and portions of enterprise risk management, I believe it is important for audit committees to not lose focus on their core roles and responsibilities.
Still, workload can be managed at least in part through consideration of the scope of the audit committee charter, agendas, education, and advisors. It is worth noting that listing standards required as a result of the Sarbanes-Oxley Act provide an audit committee with explicit authority to obtain advice and assistance from outside legal, accounting or other advisors as the audit committee deems necessary or appropriate to carry out its duties.
Audit Committee members must help each other test their judgement and instincts in landing on the important issues. Factors that lead to greater audit committee effectiveness include group dynamics, training, information reporting, and focus on substantive issues.
Tone (at the top)
Let me now turn to the effect of an audit committee on the control environment, including tone at the top. The control environment influences the control consciousness of its people. It is the foundation for effective ICFR, providing discipline and structure. A company’s control consciousness is significantly influenced by those on the board and audit committee.
A strong control environment is especially critical for company management and personnel as accounting judgments are increasingly required to be formed by many levels of individuals in the organization and disclosed in the financial statements to meet the objectives of the new GAAP standards. A strong control environment also supports the audit committee’s work.
The COSO Internal Control – Integrated Framework (2013), which companies commonly use in evaluating the effectiveness of ICFR, includes guidance for assessing the effectiveness of control environment, including tone at the top.
The importance of the audit committee’s involvement in tone and culture is further emphasized by the fact that tone and culture are one of the top challenges that audit committees believe impact the company it oversees. A significant number of audit committee members – roughly one in four in a recent audit firm survey – ranked tone and culture as a top challenge in its oversight role. The counsel of management guru Peter Drucker seems apt, “What gets measured gets improved.”
It is important for both audit committees and management to perform assessments on the adequacy of the control environment, including tone at the top. One way audit committees can focus on tone and culture is by working with management to obtain a clear and common understanding of what tone means, why tone is important, and what mechanisms are in place to assess the adequacy of control environment, including across any relevant divisions and geographies.
I believe open and candid discussions between the external auditor and the audit committee is a critical component in determining whether the organization’s tone and culture is appropriate.
Staying Current on Accounting and Financial Reporting Developments
The audit committee should also consider training and education programs to ensure that its membership has the proper background and stays current as to relevant developments in accounting and financial reporting.
New GAAP standards
In OCA, we continue to direct significant attention to monitoring companies’ implementation activities for recently-issued accounting standards, including revenue recognition, leasing, financial instruments and credit losses.
The standards advance the dual goals of improving financial reporting within the United States and reducing country-by-country disparity in financial reporting for enhanced allocation of capital.
As for the new GAAP standards:
- The revenue recognition standard is intended to improve the financial reporting of revenue and enhance comparability of this critical metric. It is permitted to be applied for most public companies in 2017 and is required to be applied in 2018.
- The leases standard is the result of more than a decade of standard-setting due process and outreach, and will increase transparency and comparability among organizations that lease buildings, equipment, and other assets by recognizing on balance sheets the assets and liabilities that arise from lease transactions. Public companies are permitted to begin applying the standards immediately, but must do so by 2019.
- The financial instruments standards include a change from the “incurred loss model” to an “expected credit loss approach” and improve the reporting for equity investments which may allow investors to have a more timely and representative depiction of a company’s arrangements.
Investors need time to absorb the effect of new GAAP standards. Accordingly, OCA has encouraged investor outreach, emphasized investor expectations for disclosure, and updated our transition disclosure guidance.
OCA also has encouraged companies, their audit committees, and their auditors to assess the quality and status of implementation to ensure that the new standards meet their objectives to better inform investors. As part of the assessment, we encourage audit committees to anticipate, and require, dialogue with the auditor about the auditor’s views of implementation progress.
Maintaining adequate internal accounting controls, representing annually to investors whether ICFR is effective, and, when required, having an independent accountant attest to the effectiveness of ICFR, promotes reliable financial reporting, strengthens public confidence, and encourages investment in our capital markets.
Over the next several years, updating and maintaining ICFR will be particularly important as companies work through the implementation of the significant new accounting standards.
OCA is committed to appropriately and timely addressing any emerging questions related to ICFR assessments and the application of the related guidance, including in coordination with the PCAOB as necessary.
Non-GAAP and Key Operational Metrics
Let me turn to another important topic, non-GAAP and key operational measures. Audit committees are well positioned to exercise healthy oversight by understanding management’s process and controls to calculate the non-GAAP and other key operational measures. For example, what procedures are in place over the accuracy of the calculations and consistency of the measures with those of prior periods?
As part of considering management’s disclosure controls and procedures it is important for audit committees to understand corporate policies in this area and if such a policy does not exist to understand the reasons why. It can also be useful to understand who is responsible for administering the policy – how many times have they approved changes in reporting, why, and should the change be communicated to investors through disclosure.
Oversight of External Auditors
Audit committees of listed companies have clear oversight authority and responsibility over the external auditor, which promotes auditor independence and greater alignment of the auditor’s interests with those of investors. The audit committee helps set the tone for the company’s relationship with the external auditor. This reporting relationship between the auditor and audit committee positions the auditor to be able to raise any contentious issues to the audit committee, in a candid, frank, and professional relationship.
Audit committees should not underestimate the importance of their role overseeing the external auditor. Auditors are accountable to the company’s shareholders, through the board of directors and its audit committee, not to management.
The audit committee responsibilities under the listing standards include the authority and responsibility to directly oversee auditor engagement terms (including proposed scope) and compensation.
In doing so, audit committees should work with other board committees as needed to monitor that important corporate objectives, such as cost reduction plans, are not unintentionally implemented in ways that would be at cross purposes with management meeting its financial reporting responsibilities or the external auditor’s appropriate audit scope, engagement terms, and compensation. Some of management’s standard procurement policies and processes may not be appropriately designed if used in the audit committee’s selection, retention, and compensation decisions for the external auditor.
Audit Committee’s Own Reporting
As it relates to the transparency of activities performed by audit committees, I am encouraged by the momentum that appears to exist for increased voluntary reporting by the audit committee over the past several years, particularly about the audit committee’s work in overseeing the independent auditor.
For example, in a recent survey, 82% of audit committees of Fortune 100 companies disclosed in 2016 that the audit committee is responsible for appointment, compensation and oversight of the external auditor. This has increased significantly from 42% just four years ago.
While strides are being made by audit committees to help investors better understand and evaluate audit committee performance, I encourage audit committee members of listed companies to continue to consider reviewing their audit committee disclosures and consider whether providing additional insight into how the audit committee executes its responsibilities would make the disclosures more effective in communicating with investors.
In considering enhanced disclosure, I recommend to audit committees and their advisors the 2015 Commission concept release which highlighted that disclosures could include a description of the nature of the audit committee’s involvement in evaluating and approving the auditor’s compensation, including how compensation is determined and evaluated.
Audit committees can help increase investor understanding of the reliability and quality of financial reporting when they provide additional insights into how the audit committee has fulfilled its responsibilities, particularly about the audit committee’s work in overseeing the independent auditor and the financial reporting process.
It has been my pleasure to speak with you today. In our time together, I have provided thoughts on how we can continue to provide investors quality financial information for their use in making investment decisions.
Before I conclude my remarks and open it up for a few questions, I would like to thank the University for the invitation. I would also like to acknowledge and thank audit committee members for the hard work in carrying out your critical roles in maintaining the strength of our capital markets.
Our capital markets are among our nation’s most spectacular achievements — they’re the envy of the world. Those markets are a rich legacy we have inherited, but do not own. We are guardians of that legacy — that the markets of our nation; that the integrity of the process; that the confidence of investors will not be compromised.
And, if we ensure the continued focus on the credibility of financial reporting that underpins our nation’s capital markets and foster investment activity in them through effective audit committees, I have no doubt that they will remain the envy of the world.