The latest rash of high-profile accounting scandals is adding fuel to the debate over reporting relationships in the finance department.
No longer satisfied with financial audits controlled exclusively by senior corporate executives and accounting firms, regulators and institutional investors are now insisting that publicly traded companies reorder some of those reporting relationships.
Under a recent proposal by a New York Stock Exchange (NYSE) committee, for example, board audit committees would have more power over external auditors. Among the audit-committee powers being championed: sole hiring and firing authority over a company's independent auditor.
Internal auditors, who until recently have typically slaved away in anonymity, focusing mostly on broad corporate controls and risk-management programs, are also being asked to take on added responsibility. But in the wake of Enron, Xerox, and WorldCom, internal auditors at some large companies — JC Penney, for instance — have begun playing key roles in setting audit-committee agendas. "I write the agenda for the audit-committee meeting," says Howard Johnson, senior vice president and director of auditing at Penney.
At other corporations, internal auditors have been asked to pore over financial statements, assuring the soundness of the numbers — or ferreting out mistakes. Indeed, management at WorldCom claims that internal auditor Cynthia Cooper uncovered the accounting ploys that ultimately forced the company to lower its stated earnings for 2001 by $3 billion.
Remarkably, WorldCom management says Cooper and Glyn Smith, another member of the internal audit staff, directly contacted the chairman of the board's audit committee, Max Bobbitt, to discuss what they had found. Bobbitt later had Cooper and Smith interview David Myers, then WorldCom's controller, about the company's treatment of payments to third-party vendors as expenses.
Some finance chiefs see internal audits as something of a sniff test for overly sophisticated accounting schemes. "If a corporation is engaging in activities beyond the understanding of the internal audit department, that's a warning sign," says Richard Marsh, CFO of FirstEnergy Corp., an Akron-based utility holding company. "If there's that kind of a disconnect, it really weakens the control function."
Edison Discovers the Audit
To beef up the function, reform advocates (among them, William Bishop of the Institute of Internal Auditors; David Richards, director of FirstEnergy's internal auditing department and immediate past chairman of the IIA; and Dorothy Heyl, senior trial counsel for the Securities and Exchange Commission) say internal auditors must have direct links to audit committees. That way, they can report concerns without fear of reprisal from their bosses.
Of course, some companies have always allowed the head of internal audit a private audience with the audit committee. Members of the NYSE's corporate accountability and listing standards committee think that the practice should be universal. In a June 6 report to the exchange's board, the committee said internal auditors should meet separately with the audit committee at least every quarter.
And the SEC is forcing those relationships on some companies. In a settlement this past May, the SEC ordered Edison Schools Inc., based in New York, to improve its financial controls by creating an internal audit department. Edison Schools also agreed to promptly hire an internal audit director, who would periodically report to the audit committee. In its order, the SEC found that Edison, a for-profit manager of public schools, violated federal record-keeping laws by, among other things, failing to properly accelerate its recognition of losses relating to agreements with certain school districts.
But the SEC also found that the company did not have "an adequate accounting system to bill [school] districts," and that its inability to address the system's weaknesses stemmed from its lack of an internal auditor. "We found the lack of an effective audit function to be a problem [at Edison]," says the SEC's Heyl.
Edison does have a CFO, Adam Feild, as well as a fairly famous chairman, Benno Schmidt Jr., the former president of Yale University. But company management adhered to the SEC's request to hire an internal audit director by June 14.
The company hired an Edison employee to direct the newly created internal audit department before the deadline, according to Adam Tucker, vice president of communications and advocacy for the company. "To maintain the independence of the internal auditing role, the Edison internal audit director reports directly to the audit committee of the board of directors of Edison Schools, and not to senior management," says Tucker.
Function at the Junction
At most large public companies, however, the issue isn't whether there is an internal auditor, but who the auditor's boss should be. It's one thing for regulators and investors to say the internal audit department should get its general marching orders from the board audit committee, but internal auditors usually report to the CFO.
The most popular solution, according to the IIA, is to provide auditing executives with two masters: the audit committee for policy-making and a senior corporate executive — usually the CEO — for more-routine work.
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