(The article featured below is a selection from PCAOB Reporter, which is available to subscribers of that publication.)

Conference Panelists Review Issues Affecting Audit Committees

Wayne Carnall, the chief accountant for the SEC's Division of Corporation Finance, said the number one public policy debate surrounds the potential loss of U.S. sovereignty over accounting standards. In remarks at the Practising Law Institute's Audit Committee Workshop, Carnall also reported on the recommendations by the SEC's Advisory Committee on Improvements to Financial Reporting. The final recommendations will be submitted within the next two weeks and include actions related to professional judgment, materiality and the correction of errors in financial reporting.

Carnall noted that the SEC has already responded in part to one of the Advisory Committee's recommendations by issuing a statement on the procedures to follow when asking the staff to reconsider a view stated in a comment letter. A company should never feel that it has been forced to restate its financial statements, he advised. Carnall said that companies will always make errors in preparing their financial statements, so the key is to evaluate the materiality of those errors.

Staff Accounting Bulletin No. 99 provided guidance on materiality that was based on case law, according to Carnall. Nothing that the staff has done since then has superseded that guidance, he advised. Carnall said that companies must look at the totality of information when considering materiality. They should conduct a careful analysis of the facts and review what has been publicly disclosed. The passage of time does not make a material error nonmaterial, he said, but it may affect how a company fixes it. The staff is considering the Advisory Committee's recommendation for correcting financial reporting errors.

John Olson, a partner with Gibson, Dunn & Crutcher and co-chair of the conference, asked whether the staff is working on a project to provide guidance on the use of judgment. Carnall said that any guidance would be issued at the discretion of the Commission, but added that the staff will respect professional judgment that follows the applicable procedures.

Mary Bush, the president of Bush International, LLC, reported on a proposal that is circulating from the Institute of International Finance, Inc. on the application of fair value accounting in illiquid conditions. One idea under consideration by the IIF's Committee on Market Best Practices is an alternative valuation methodology for illiquid market conditions involving the use of underlying discounted cash flow. The burden of proof would be on the issuer when using this method, she said, and would rely heavily on full disclosure.

PCAOB member Daniel Goelzer was asked about the inspection teams' interviews of chairs of audit committees. Goelzer said the staff is simply trying to learn about audit committees' communications with the auditors. Since the inspection reports are part public and part nonpublic, Goelzer said they are not designed as a communication tool. Some have suggested that the reports are not useful at all, he added. The reports do not name the issuers where audit deficiencies were found, according to Goelzer, but he believes that issuers would like to know from their auditors if they are mentioned.

Bush believes it is important for audit committees to get their hands on the part of the PCAOB's assessment of their audit firm that is public. She has asked for the confidential part of the report but has not had any success, she said. Olson noted that audit committees can ask for a briefing on the PCAOB's inspection report. There are no legal restrictions that prevent auditors from sharing that information, he said.

Goelzer touched on the PCAOB's proposal relating to engagement quality reviews. A number of commenters said the PCAOB missed the mark with respect to the costs of the proposal, he said. However, no issuers commented on the proposal. Goelzer also mentioned a proposal by an advisory committee on the auditing profession that would require the disclosure of objective measures of audit quality. The proposal is somewhat controversial, he said.

Improving Audit Committee Effectiveness

Edward Smith, the executive director of KPMG's Audit Committee Institute, reviewed ways to improve audit committee effectiveness. Audit committee members must understand the company's significant accounting principles, he said, and must be financially literate. Many audit committees have more than one financial expert, he advised. Audit committee members must keep an eye on what is new, he said. Smith reported that at a recent seminar, 75% of the audit committees represented had not discussed international financial reporting standards.

Bush suggested the evaluation of individuals on the audit engagement team once a year. The audit committee should ensure that the team is communicating clearly and frankly with respect to any issues of concern. The team should also be willing to counsel the committee on accounting policies, she said, which many firms were reluctant to do in the post-Sarbanes-Oxley Act years. In recent years, that tendency has been reduced, she said. Bush believes it is very important that management and the audit committee members know the range of acceptable policies and where there might be vulnerabilities.

Peter Gleason, the managing director and CFO at the National Association of Corporate Directors, reported on risk management oversight, which he said is the emerging top priority for audit committees. Their top risk management concerns include economic considerations, the potential for earnings management and the accuracy of asset modeling in light of the recent subprime market crisis.

Gleason noted that international financial reporting standards are "barreling down on us," which is another big concern. In addition to tone at the top, he said audit committees must consider "tone at the middle," such as the staff in the internal control area and those who serve as stopgaps for earnings management. Gleason noted that the turnover rate at the CFO level is reportedly 40% higher than it was two years ago.

Olson noted with respect to turnover in a company's financial reporting operations that the audit committee has a responsibility for knowing who the gatekeepers are and if someone leaves, why.

Meredith Cross, a partner with Wilmer Cutler Pickering Hale and Dorr LLP, agreed that risk management oversight is the top priority for audit committees and one with which they struggle. She noted that many were surprised when access to capital dried up the way it did in the Bear Stearns matter. She said that companies should have a contingency plan to manage liquidity risk. Companies also face counterparty risks, commodity and supply risks, legal and reputational risks and financial reporting risks, she added.

Cross said that disclosure processes require careful oversight. Audit committees must also be prepared for new standards, including FAS 5, a new acquisitions standard and the eventual mandatory filing in XBRL.

Bush outlined a checklist of issues the audit committee is responsible for and must allocate time to consider such as fair value accounting, liquidity issues and asset-backed securities. The agenda for each meeting should be set out in great detail at the end of the previous year, she said. It should be reviewed by legal counsel and the outside auditor. The outside auditor may highlight significant issues that will require additional attention in the coming year, she said.

Bush urged audit committees to take a risk-based approach to the agenda. Among the potential time savers is to include the outside auditor in the meetings and to read all of the materials ahead of time to eliminate the walk-through of every item. The chairs of every committee should be aware of the issues that may affect other committees, she said.

Cross said that additional time savers include having management highlight what has changed such as litigation or additions to the hot line log. She suggested that related-party transactions be moved to the governance committee if they currently reside with the audit committee.

Olson advised that training on current accounting issues may require outside expertise. The audit committee should seek independent advice if it is not getting all of the information it needs from the company. The minutes of the meeting should note the key items that were discussed, along with the beginning and ending time. Executive session minutes should state who attended and the issues that were addressed, he advised.

Risk Management

Carnall believes there is a strong desire for a single set of global accounting standards. A few years ago, U.S. GAAP would have been presumed to be that standard, he said, since it is a more mature basis for accounting. However, for various reasons, that is no longer the case so the U.S. must now consider how to transition to international financial reporting standards.

Carnall noted that Europeans do not want to change their standards. He was skeptical about the degree of convergence that will occur, but noted that FASB and the IASB have a number of convergence projects they would like to complete. IFRS is already here, he added, and he believes it is important that the U.S. be a significant player in the global accounting process.

Carnall referred to the myth that IFRS is a more principles-based standard while GAAP is more rules-based. Both are very much based on principles, in his view. IFRS can be more difficult to apply since a registrant must decipher the economics of the transaction, he explained. He also discounted views that IFRS calls for less disclosure. More reliance on judgment requires more disclosure, he said. Carnall has heard concerns that the SEC will be unable to review or challenge IFRS. The staff will review IFRS the same way that it reviews GAAP, he advised.

The panelists discussed whether the transition to IFRS should be optional rather than mandatory and what the time frame should be. The SEC plans to develop a roadmap that outlines the transition process. Carnall said it will not be a staff paper, but a document from the Commission. Cross added that the new Commission may change the outcome. Three new commissioners were recently confirmed.

Teresa Iannaconi, a partner at KPMG LLP, noted that the PCAOB has been very critical about documentation which concerns firms since the inspection reports are public. Documentation is a greater concern from the PCAOB standpoint than from a litigation perspective, she added. Carnall said that most restatements are a result of the lack of compliance with the accounting standards, not due to the judgment upon which a company relied.

Carnall noted that some companies do not want to adopt IFRS until it is mandatory. Many companies want the SEC to establish a date for mandatory compliance. Companies can choose to provide any information they think is appropriate right now, he added, including comparisons of their financial statements under IFRS and GAAP.

Nicolas Grabar with Cleary Gottlieb Steen & Hamilton LLP advised that IFRS is different from GAAP and will be different for U.S. companies than for European companies in its application. Any large company with multinational operations should be following the developments, he said. If a company has difficult accounting issues, someone should follow how they would work under IFRS, he said. Small domestic companies can probably wait awhile to become conversant with IFRS, in his view.

Grabar listed some of the questions surrounding a move to IFRS including the need for training, systems changes such as internal controls, and compensation arrangements. He said the costs are unknown and raised the specter of section 404 all over again.