audit committee Best Practices F o r Audit Committees result of the accounting scandals of recent fears is the enormous attention given to audit committees of public compa- nies and the subsequent change in the committee's rote and practices Th e Sarbanes-Oxley Act of 2002 effec- tively transferred certain powers from the CEO and the CFO to the audit com- mittee. The enhanced role requires audit committee members with more expertise to devote substantially more by Frederick D. Lipman 1 stablish an effective internal audit function that reports to the audit committee. Estab- lishing such an internal audit func- tion is probably the most important thing the audit committee can do. The internal auditor must be hired a n d compensated by the audit committee of the hoard of directors. The primary responsibility of the internal auditor should be to assist the board In per- forming its fiduciary duty to monitor management — or, in other words. The public company audit committee now has an enhanced role and needs to revise some of its practices. Here are some key areas to focus on. act as the eyes and ears of the audit committee. Other operational duties may be assigned to the internal auditor by management, but these other duties should not interfere with the primary responsibility of the internal auditor. It is clear from the WorldCom Inc. time and effort to their task. In deed, in many cases^ time spent on audit committee work ha s increased as much as 100 percent. in light of these changes, spurred not only by the scandals but the new rules and regulations that followed the scan- dals, there are some key areas to focus on . The following discusses 1 0 best practices for audit committees summarized from a list of 30 that are included in a new book on the subject by this author. fiasco that the audit committee must control the operations of the internal audit department to the extent that those functions deal with the audit of financial reporting. WorldCom'.^ audit committee allowed manage- ment to control the internal audit department and created an incentive structure that required the internal audit group to emphasize opera- tional audits, which saved money for WorldCom or otherwise produced "value." This resulted in an internal October 2006 www.fei.org 49
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rities Exchan ge Act of 1934. Toensure auditor independence, the
audit committee should adopt these
policies:
a. The enga gem ent letter from the
auditor should contain a represen-
tation that the auditor is and will
remain inde pen den t (as defined by
Securities and Exchange Commis-
sion (SEC) rules) throughout the
audit engagement.
b. Conduct a robust discussion with
the auditor of its independence atleast once a year. This robust dis-
cussion should include any rela-
tionships witb management that
migbt impair the objectivity of the
auditor. For example, it was
reported that KPMG LLP, the
aud itor for First Union Corp . (now
part of Wachovia Corp.), received
referrals from First Union of
wealthy banking clients and First
Union was, in turn, paid referral
fees by KPMG LLP. Some have
questioned whether this type ofrelationship could compromise
the impartiality of the auditor.
c. After each assignment of nonaudit
work to the auditor, the auditor
should be required to represent to
the audit committee that the
nonaudit ser\ ice does not impair its
independence. (An exception may
be made for routine nonaudit serv-
ices, such as tax return prepara tion.)
d. Care mu st be taken before hi ring
former employees of the auditing
firm as company employees, to be
certain that tbe new employee will
not impair the auditor 's independ-
ence. The HR department should be
required to notify the audit com-
mittee prior to any such hires.
Refrain from using the auditor
for tax planning and tax
preparation services. Although
tax planning services do not impairthe independence of auditors under
SEC rules, audit committees should
consider whether using the auditor for
tax planning services is in the best
interest of the company.
The audit committee should con-
sider, amon g other things, the fact that
the auditor is prohibited by auditor
independenc e rules from p roviding an
expert opinion or other expert services
for an audit client, or acting as an
audi t client's legal representativ e, forthe purpose of advocating an audit
client's interests in litigation or in a
regulatory or administrative pro-
ceeding or investigation.
The effect of this prohibition is
that the auditor is unable to assist
the company in advocating the
company's tax position before the
Internal Rc\'cnuc Service (IRS),
since the IRS inquiry might be
viewed as a "regulatory or admin-
istrative proceeding or investiga-
t ion ." Although the auditor is per-
mitted to be a fact witness in such
proceedings or investigations, i ts
inabi li ty to advocate the com pany 's
tax position handicaps the company
in the defense of its tax planning.
Carefully consider the
impact of the indepen-
dent audi tor ' s preferred
account ing t reatment . Sarb . ines-
Oxley and SEC rules require the inde-
pendent auditor to disclose any
accounting treatments preferred by
them. The audit committee must
determine on a case-by-case basis
whether any of the accounting treat-
ments preferred by the independent
auditor should be adopted by the
company and what the overall effect
would be of such adoption.
If the audit committee decides not
to adopt an independent auditor 's
preferred treatment, the reasons forthe rcjfcHon should be carefully doc-
umented by the audit committee,
with the assistance of counsel, in
order to protect the audit committee
from persona! liability.
Frederick Lipman is a Partner with
Blank Rome LLP and President of the Asso-
ciation of Audit Committee Members Inc.
The 10 audit committee best practices
described above are taken from 30 best
practices described in greater detail in Lip-man's book, Corporate Governance Best
Practices, published by John Wiley &
Sons Inc., 2006, and available in book-
stores and on Amazon.com.
One result of the accounting scandals in recent yearsis the att ent ion given to audit comm ittees of publiccompanies and the subsequent change in the commit-tee's role and practices.
The Sarbanes-Oxley Act effectively transferred certainpowers fro m the CEO and CFO to the audit comm ittee.
Establishing an effective internal audit function isprobably the most important thing the audit commit-tee can do.
Among the steps audit committees should takeis to carefully consider the independent auditor'spreferred accounting treatment.