Reforming The Once Obscure Corporate Audit Committee

By Patrick O’Keefe
Principal
O’Keefe & Associates

Until recently, the composition and role of corporate audit committees wasn’t an issue most investors worried about. Due to the standardization of the audit procedure, the audit committee had few responsibilities and therefore, the most inexperienced board members were assigned there. However, recent events have brought audit committees and their part in corporate governance to the forefront. Due primarily to the troubles at Enron and to a lesser extent at Tyco and others, the scrutiny under which audit committees fall has risen dramatically. The increased examination has lead to many proposed changes, not only in the role of audit committees, but in the rules governing the accounting industry and business in general.

One proposed change is the creation of a new oversight body to regulate and discipline corporate accountants, who in the past have been self-regulated. The House of Representatives recently passed a bill sponsored by Financial Services Committee Chairman Michael Oxley (R-Ohio) that would create such an oversight body. This new regulatory body would be part of the SEC and would be responsible for overseeing the accounting industry and for certifying and disciplining accountants. The so-called Oxley Bill would also prohibit auditors from providing some non-audit services, such as consulting on internal audit and information technology matters. However, some believe that the only way to ensure auditor objectivity and independence is to completely ban auditors from providing all consulting services.

The Business Roundtable, an influential group of U.S. business executives, recommends that there be a mandatory “cooling off” period before auditors could go to work for their clients. If auditors are angling for jobs from their clients, they are less likely to be completely objective and critical. The Roundtable also suggested that companies be required to periodically change auditors. The theory behind this suggestion is that auditors who know their work will be reviewed by another firm in a few years will probably be more diligent in their audit.

A change contemplated by others is that auditors be made accountable to shareholders, represented by the board of directors, instead of to management. Doing this would obviously increase the role of the audit committee. Audit committees would take over responsibility for hiring and/or firing outside auditors as well as for evaluating the performance of the outside auditors on a yearly basis, with the desired result being increased auditor independence. This reform is a far cry from just negotiating audit fees. The Business Roundtable also proposed that more emphasis be placed on having independent directors on the audit committee with no personal or financial ties to either the company or management.

Problems Did Exist
But why are these changes necessary? What was wrong with the system? First of all, there were conflicts of interest. Accounting firms were using the audit as a loss leader to gain profitable consulting contracts. Firms sensitive to endearing themselves to management rather than being the whistle blower and corporate watchdogs the public expects would obviously be willing to overlook a few things in the audit in order to maintain their consulting relationships.

Lack of independence has been another major problem. Audit committee members have had serious ties to either the company or management. In the case of Enron, the company made donations to several organizations with which the audit committee members were associated. In other cases, members of management were part of the audit committee. Many audit committees never met without management present, undoubtedly reducing the candidness of discussions.

Surprisingly, most audit committee members had little or no financial knowledge. As I mentioned earlier, the most inexperienced board members were placed on the audit committee. Often, these board members were famous people with no real business experience. The audit committee was seen as a place where these board members could not do much harm. For example, O.J. Simpson once served on the audit committee of Infinity Broadcasting.

These audit committees also met infrequently. Lynn Turner, former Chief Accountant for the SEC, once recommended that audit committees meet a minimum of four to six times per year. However, many studies have shown that many audit committees meet less than that. The audit committee for CUC International, which merged with HFS Inc. to form Cendant Corp., met only twice in the year prior to the merger, while the compensation committee met eight times.

Is Reform on the Way?
These audit committee flaws have existed for some time, yet only recently have become exposed. In 1999, the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees issued recommendations to improve audit committees. As a result, the stock exchanges, the AICPA, and the SEC all adopted new rules and requirements concerning auditors and audit committees, specifically regarding audit committee members’ independence and financial literacy. 

However, these new rules did not completely address the problem, since there were loopholes in the rules allowing companies to sidestep them. For example, the new rules allowed one member of the audit committee to violate the independence requirements as long as the board determined that it was in the best interests of the company and its shareholders to have a non-independent board member on the audit committee. 

On top of the fact that there were loopholes, audit committees at the time were just not prepared for the new rules. USA Today quoted Ken Bertsch, director of corporate governance at money-management firm TIAA-CREF, back in July of 2001 as saying, “Audit committees aren’t up to the new requirements, but you can’t see that until something blows up.” Which, of course, is exactly what happened.

When all is said and done, corporate audit committees will have many new duties and responsibilities that they did not have before. One such duty is to oversee independent auditors. Management should not be responsible for hiring/firing auditors and for establishing audit fees, nor should the independent auditor report to management as their “boss”. The audit committee may now have to sign off on SEC filings, which will subject them to increased liability. With this increased liability comes increased time commitment. Audit committee members can no longer spend approximately eight hours a year on the job. They must spend more time reviewing SEC filings, auditor/management relationships, etc. And again, independence is vital. Audit committee members will now be required to be entirely independent of the company, with very few exceptions.

Whether or not these new reform attempts work any better than past attempts remains to be seen. One thing, however, is certain—the composition and role of audit committees is no longer an issue that investors will ignore.

Patrick O’Keefe is founding principal of Bloomfield Hills, Michigan-based O’Keefe & Associates, a financial and operational management consulting firm specializing in creditor and bankruptcy services; business valuation; turnaround consulting and debt restructuring; litigation support; forensic accounting; and due diligence on strategic transactions. He can be reached at: pokeefe@okeefac.com. Craig Baker also contributed to this article.