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Chief Accountant Herdman Addresses Audit Committees

SEC Chief Accountant Robert Herdman told the Tulane Corporate Law Institute that effective audit committees must have three key qualities. According to Mr. Herman, the committees must 1) control their agendas, 2) exercise diligence and 3) ask the hard questions. Mr. Herdman emphasized that, while the rules are important, "it is the attitudes and approach of those entrusted with carrying them out that determine whether the exercise has a positive impact."

Agenda Control

Initially, he suggested that the audit committee must control the agenda in dealing with the following matters. It must evaluate the competence and independence of the independent auditors, and in particular of the partner who is leading the audit. Mr. Herdman stressed that when an auditor provides other services to the company that this relationship must not create a "debt" that management can have repaid when a tough financial reporting issue arises.

According to the chief accountant, the audit committee must probe to find out about issues to which management and the auditors are giving considerable attention. This is true even if there were no "reportable disagreements" that could produce a qualified audit opinion. Mr. Herdman noted that it should be expected for management to want to take a more aggressive approach on some issues. But, he emphasized, the audit committee still needs to hear about those issues and the nature and outcome of the discussions between management and the auditors.

Another item on the audit committee's agenda is internal control and the internal audit function. This is crucial to the company in stemming fraud and abuse and in preparing accurate financial statements. The audit committee must understand the company's internal control structure and be able to assess the internal audit's effectiveness in order to ensure that "this important link in the chain is solid," advised Mr. Herdman. Suggestions by the internal and external auditors for improvements in controls must be adopted absent compelling circumstances, he said.

Presently, the chief account indicated that most audit committees capably handle the next agenda item, the discussions of the scope of work that the auditors plan to carry out as a result of their assessment of controls and other planning efforts. However, he said, audit committees can do a better job of considering the audit fee as a way to monitor whether the scope of work is sufficient.

Other items on which the agenda should focus include management and the corporate code of conduct. The audit committee should ask for and receive candid assessments of the competence of financial management, while being "champions of corporate codes of conduct," said the chief accountant. The audit committee also should have direct, unrestricted access to management, internal audit staff and the external auditors, and should be able to communicate in confidence with those three groups, independently of each other. Mr. Herdman also noted that the audit committee has a role in meeting with the SEC with regard to unusual accounting issues. so the SEC staff can learn the audit committee's view of the proposed accounting treatment.

Diligence

The second key quality for audit committees is diligence, which Mr. Herdman defined as perseverance, earnestness, attention and care. The audit committee can enhance its diligence by being proactive in analyzing the information they receive from management. He suggested that audit committee members should begin by discussing and understanding the company's critical accounting policies. Understanding such issues is critical, stated Mr. Herdman, and he noted that "audit committee members cannot walk away if they don't understand a material transaction, the economics, or the accounting behind that transaction, no matter how complex."

Mr. Herdman recommended three key questions for audit committees to consider. Initially, the audit committee should review whether the financial statements would have been prepared differently from the manner selected by management if the auditor were solely responsible for preparing the company's financial statements. Next, the committee should ask if an investor would receive the information essential to a proper understanding of the company's financial performance. Finally, he urged audit committees to examine if the company would follow the same internal audit procedure if the auditor were the CEO.

Time Requirements

Finally, audit committee members must devote sufficient time to gain an adequate understanding of what the company's financials represent. They must have enough time to consult with outside counsel and experts if necessary; to ask tough, incisive questions; and to obtain answers that make sense. Essential factors are proper advance planning, conduct of meetings and follow-up. According to Mr. Herdman, it is not enough for the audit committee members to spend a few hours together per year. Their duties properly require more time than that for examining the company's accounting policies, reading the financials and MD&A for clarity and understandability, involvement with quarterly financial statements and compliance with laws and regulations.