Improve audit committee effectiveness

1
Audit Committee Effectiveness

• Improve audit committee effectiveness
• Increase oversight diligence by audit committees
• Reduce cases of improper financial reporting as a
  result of these improved audit committee
  practices.

2
Warning Signs for Risk of Financial Fraud

• Unusual results or trends relative to industry
• Overt pressure by CEO on Operating Heads to Make
  the Numbers
• Unrealistic earnings expectations by financial
  community fueled by managements unrealistic
  growth goals
• Complex organizational structures or transactions

3
Warning Signs for Risk of Financial Fraud

• Inexperienced management in concert with rapid
  growth rate
• Frequent organizational changes and high turnover
  of senior management
• Autocratic management and inappropriate Tone at
  the Top

4
Warning Signs for Risk of Financial Fraud

• Excessive or inappropriate performance based
  compensation
• Ongoing or prior investigations by regulators or
  others
• Untimely reporting and responses to Board and
  Audit Committee

5
Earnings Management SEC Perception

• Overstatement of Big Bath charges
• Misuse of acquisition accounting
• Creation and use of Cookie Jar reserves
• Premature revenue recognition
• Improper deferral of expenses
• Misuse of materiality concept

6
Chairman Levitts Action Steps

• Request Public Oversight Board to review
  effectiveness of audits
• Establishes Blue Ribbon Panel on Audit Committees
• SEC makes inquiries of companies that report
  significant write-offs in 1998
• Detailed review of accounting issues on
  registration statements filed with the SEC

7
Chairman Levitts Action Steps

• SEC staff to issue Accounting Bulletins on
  Revenue Recognition, Recording of Reserves and
  Materiality
• Formation of Earnings Management Task Force by
  Division of Corporate Finance and close
  coordination with Enforcement Division
• Requests AICPA to review rules on Auditor
  Independence - creation of Independence Standards
  Board

8
Blue Ribbon Panel Recommendations

• Independence of Audit Committee Members
• Composition of Audit Committee
• Qualifications of Audit Committee members
• Adoption of Audit Committee Charter

• SRO
• SRO
• SRO
• SRO

9
Blue Ribbon Panel Recommendations

• Disclosure in Proxy Statement about Charter and
  compliance therewith
• Outside auditor is accountable to Board of
  Directors
• Outside auditors provide Audit Committee with
  written Statement on Independence

• SEC
• SRO
• SRO

10
Blue Ribbon Panel Recommendations

• Outside auditors discuss with Audit Committee
  their judgement about quality of accounting
  principles
• Audit Committee Letter in Annual Report
• Quarterly SAS 71 reviews and discussion of
  results with Audit Committee

• AICPA
• SEC
• SEC/AICPA

11
Independence of Audit Committee Members - 1
(SRO)
Committee members are considered independent if
they have no relationship with the corporation
that may interfere with the exercise of their
independence from management. FEI supports
this provision, but suggests that exceptional
and limited cases of important directors be
allowed to serve if the full Board finds it in
the best interest of the Company. Exceptions
would then be disclosed in the proxy.
For Companies with market capitalization over
200 million
12
Independence of Audit Committee Members - 1 (SRO)
Examples of conflicts of independence are

• Director being employed by corporation (or
  affiliates) for current and any of the past 5
  years
• Director receiving compensation other than for
  Board service
• Director being related to anyone who has been
  executive officer of the corporation in any of
  the past 5 years

13
Independence of Audit Committee Members - 1 (SRO)
Examples of conflicts of independence, continued

• Director being a principal or executive officer
  of an entity to which the corporation made or
  received payments in amounts that are significant
  to the corporation or entity
• Director being employed as executive of another
  company where any of the corporations executives
  serve on that companys Compensation Committee

14
Composition of Audit Committee - 2 (SRO)
In addition to compliance with definition of
independence (in Recommendation 1)

• All listed companies with market capitalization
  above 200 million should have Audit Committee
  comprised solely of independent directors
• FEI supports this provision

15
Qualifications of Audit Committee Members - 3
(SRO)

• Audit Committee should be comprised of a minimum
  of three directors
• Each member should be financially literate or
  become financially literate within a reasonable
  period of time after appointment
• One member of Committee should have accounting or
  related financial management expertise
• FEI supports this provision.

For Companies with market capitalization over
200 million
16
Adoption of Audit Committee Charter - 4 (SRO)

• Adopt a formal, written Charter that is approved
  by the full board
• Specify the scope of responsibilities and how
  those responsibilities are carried out, including
  structure, processes and membership requirements
• Review and reassess the adequacy of the Charter
  on an annual basis
• FEI supports this provision

17
Disclosure in Proxy of Charter and Compliance
Therewith - 5 (SEC)

• Company is required to have its Audit Committee
  disclose in its annual Proxy Statement whether
  Audit Committee has adopted a formal written
  Charter
• Audit Committee to also state whether it
  satisfied its responsibilities in compliance with
  Charter

18
Disclosure in Proxy of Charter and Compliance
Therewith - 5 (SEC)

• Charter is to be disclosed triennially in annual
  report or proxy and in any year after significant
  amendments are made to the Charter
• It is recommended that SEC adopt a Safe Harbor
  applicable to all disclosures in this
  Recommendation 5
• FEI supports this provision.

19
Outside Auditor is Accountable to Board of
Directors - 6 (SRO)

• Charter to specify that outside auditor is
  ultimately accountable to Board of Directors and
  the Audit Committee as representatives of
  shareholders
• The above representatives have ultimate authority
  and responsibility to select, evaluate and where
  appropriate replace the outside auditor or to
  nominate an outside auditor to be proposed for
  shareholder approval in Proxy
• FEI generally supports this so long as there is
  no limitation on the ability of the Board to
  specifically delegate responsibilities it deems
  appropriate.

20
Outside Auditors Provide Audit Committee with
Written Statement on Independence - 7 (SRO)

• Charter to specify that Audit Committee is
  responsible for obtaining a formal written
  Statement of Independence from outside auditors
• Statement should delineate all relationships
  between auditor and company and be consistent
  with the Independence Standards Board (Standard 1)

21
Outside Auditors Provide Audit Committee with
Written Statement on Independence - 7 (SRO)

• Audit Committee is responsible for actively
  engaging in a dialogue with the auditor with
  respect to any disclosed relationships or
  services that may impact the objectivity or
  independence of the auditor
• FEI supports this but does not want to see the
  restrictions on corporations ability to hire
  accounting firm personnel

22
Outside Auditors Discuss with Audit Committee
Their Judgement About Quality of Accounting
Principles - 8 (AICPA)

• Discuss quality, not just the acceptability of
  accounting principles as applied in financial
  reporting
• Include

• clarity of financial disclosures
• degree of aggressiveness or conservatism of
  accounting principles and underlying estimates
• other significant management decisions regarding
  financial disclosures

23
Outside Auditors Discuss with Audit Committee
Their Judgement About Quality of Accounting
Principles - 8 (AICPA)

• FEI does not support this recommendation because
  

• Very concerned that this moves the audit
  committee out of oversight role and into
  managements and the auditors role
• A THREE-WAY DISCUSSION should take place on the
  most appropriate accounting policies between the
  audit committee, management and the outside
  auditor

24
Audit Committee Letter in Annual Report - 9 (SEC)

• Letter should disclose whether or not

• Management has reviewed the audited financials
  with the Audit Committee, including a discussion
  of the quality of the accounting principles
  applied, etc.
• The outside auditors have discussed with the
  Audit Committee their judgements regarding the
  quality of principles applied, etc.

25
Audit Committee Letter in Annual Report - 9 (SEC)
Letter should disclose whether or not

• Members of the Audit Committee have discussed
  information disclosed to them by management and
  outside auditors
• The Audit Committee, in reliance on the above,
  believe that the companys financials are fairly
  presented, in all material respects, in
  conformity with GAAP
• It is recommended that the SEC adopt a Safe
  Harbor applicable to any disclosure in this
  recommendation

26
Audit Committee Letter in Annual Report - 9 (SEC)

• FEI opposes this requirement because it is
  putting the Audit Committee into an audit and
  attest function as opposed to an oversight
  function.
• The proposal would be supported under the
  following conditions

• Eliminate requirement for audit committee to
  affirm compliance with GAAP - not ACs job.
• Include details on how it carried out its
  responsibilities as addressed in recommendation
  4.
• Requirements in 4 and 9 should be combined

27
Quarterly SAS Reviews and Discussions of Results
with Audit Committee - 10 (SEC)

• Requires that outside auditor conduct a SAS 71
  interim financial review prior to company filing
  its Form 10-Q
• Recommends that SAS 71 be amended to require
  outside auditors to discuss significant issues
  with at least the chairman of the Audit
  Committee, including

• significant adjustments
• management judgements and accounting estimates
• significant new accounting policies
• disagreements with management

28
Quarterly SAS Reviews and Discussions of Results
with Audit Committee - 10 (SEC)

• FEIs concern is that NO PROVISION is
• made for cost/benefit considerations
• - we agree the auditor should at all times
  have access to the audit committee if the need
  arises
• Certain provisions seem bureaucratic and
  unwarranted. Will add to going through the
  motions syndrome.

29
Problem Identified

• Audit committees that are going through the
  motions of oversight without exercising strong,
  independent and objective oversight on behalf of
  the shareholders.

30
What Makes Americas Capital Markets so Great?

• Economy, free market and incredible liquidity -
  no doubt, but structural factors too
• Independent accounting standards
• Audited financial statements certified by
  independent third parties
• High standards of corporate financial reporting
• System of corporate governance
• Legal system and highly evolved corporate,
  securities case law
• Incredible evolution of facilitators - rating
  agencies, analysts, investment and commercial
  bankers

31
Corporate Governance in America

• Participants
• Shareholders
• Board of Directors
• Management and employees
• The Public

32
Goals of Corporate Governance

• To ensure that the corporation operates in the
  best interests of its shareholders
• Representative methodology
• Annual election of directors
• Major matters require the vote of shareholders
• issuance of stock, mergers, changes to bylaws
• Boards operate through committees
• audit, compensation, nominating, executive,
  finance

33
The Three Legged Stool of Financial Reporting
1. Company financial management 2. Board
including the audit committee 3. External
auditors Each has a role. Each has certain
specialties and capabilities in terms of
expertise, time and depth of familiarity.
34
Audit Committees Best Practices

• The Audit Committees key role in monitoring the
  other component parts of the audit process
• Independent communication and information flow
  with internal auditors
• Independent communication and information flow
  with outside auditors

35
Audit Committees Best Practices

• Candid discussions with management, the internal
  auditor and outside auditors regarding issues
  implicating judgement and imparting quality
• Diligent and knowledgeable membership