Enhancing Audit Committee Effectiveness

What factors help companies avoid financial reporting problems? What makes the audit committee of a corporate board of directors effective? Looking at the reporting problems experienced in some financially troubled companies and examining the roles that audit committees play can provide valuable clues. The National Commission on Fraudulent Financial Reporting, chaired by James Treadway (the Treadway commission), and the Public Oversight Board (POB) of the SEC practice section of the American Institute of CPAs have made recommendations on the attributes needed to enhance audit committee effectiveness and to improve the quality of financial reporting. This article reports on a study examining differences in the composition and meeting habits of audit committees of companies with and without financial reporting problems. By understanding the committees of problem companies, auditors should be able to anticipate and thus help companies avert financial reporting difficulties. The U.S. accounting profession is not alone in focusing on audit committees and their effectiveness. They also have become issues of interest to U.S. regulators and to professional accounting bodies in other countries. For example, the Macdonald commission in Canada and the Cadbury committee in the United Kingdom have addressed the importance of audit committees in the corporate governance process. The advisory panel on auditor independence appointed by the POB highlighted the role of audit committees in the financial reporting process. (See "How Directors and Auditors Can Improve Corporate Governance," JofA, Jan.96, page 53.) Among other issues, the panel stressed the importance of informed dialogue between the independent auditors and the audit committee. The panel also recommended that auditors be brought into the mainstream of corporate governance and suggested possible improvements in the interaction between auditors and audit committees. Prompted by such calls, the AICPA auditing standards board is engaged in a project to determine whether communications between auditors and the audit committee can be improved. Given such professional attention to audit committees, CPAs may be interested in the characteristics of the audit committees of companies with and without financial reporting problems. For example, the Treadway commission found that a significant proportion of companies cited in actions by the Securities and Exchange Commission had audit committees. Thus, simply having a committee is not enough--for it to perform effectively, it must be independent, informed and vigilant. Why should auditors be concerned about audit committee composition and activities? In its 1993 special report, In the Public Interest, the POB noted that auditors "should assist the audit committee and the board in understanding their responsibilities and the best practices to follow. The auditor should.indicate the areas in which the committee's procedures could be strengthened. " Such actions, the POB noted, also would serve to reduce the danger of litigation against the auditor. SURVEY DATA BANK Our survey examined 51 companies with one or both of two types of financial reporting problems: (1) SEC enforcement actions and (2) material restatements of quarterly earnings. For comparison purposes, we selected an initial random sample of 100 companies with no financial reporting problems; however, complete data were available for only 77 of them. To enhance the power of our analysis, we concentrated on the four-year period before 1989. As of February 1, 1989, the national market system of the NASDAQ required audit committees for all registered companies. (The New York Stock Exchange had required audit committees since 1978; the American Stock Exchange did not follow suit until 1992.) DIFFERENCES BETWEEN COMPANIES Some variations were observed between companies that had problems and those that did not. …