Corporate Finance

Watchdogs or Lapdogs?

Audit committees may not be as bad as the SEC thinks--or as good as they should be.
Stephen BarrMay 1, 1999

The more things change, the more they stay the same. At least as far as audit committees are concerned. Twenty-five years ago, the Securities and Exchange Commission uncovered millions of dollars in illegal campaign contributions and payoffs to foreign governments by defense and aviation giant Lockheed Corp. Eventually, 400 or so firms were investigated for similarly questionable, “off-book” payments. One common factor: the companies’ boards either did not have a functioning and qualified audit committee or had a committee of members with obvious ties to management.

Thus began the first real push for effective audit committees. In 1976, then-SEC chairman Rod Hills persuaded William Batten, the head of the New York Stock Exchange, to require that audit committees have independent directors as a condition of listing. New standards were soon adopted, though never strictly enforced. And as part of the SEC’s settlement with Lockheed, the agency gave approval to who would serve on the company’s new audit committee.

Today, the SEC is again pushing for improved audit-committee effectiveness; the stock exchanges are again reviewing their listing standards for audit committees; and Lockheed’s successor company, Bethesda, Maryland-based Lockheed Martin Corp., has again come in for some criticism.

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Buried in an SEC filing last November was the disclosure that 25 percent of Lockheed’s net income for the third quarter was generated by an adjustment of accounting reserves. Although it is not unusual for defense companies to show regular accounting gains and charges, the size of this one raised eyebrows.

After a scathing article on the earnings adjustment ran in the Wall Street Journal, the stock price began to tumble. The inevitable class-action complaint alleging fraud and insider trading was filed in January.

The earnings adjustment occurred while the former CFO of Lockheed Martin sat on the audit committee. Vincent Marafino, who retired in 1995, sold some $11.2 million in stock last year and received a $250,000 annual retainer from the company for consulting services. Along with five other board members and executives, he was named a defendant in the shareholder suit.

Says Hills, who left the SEC in 1977 and is currently on the audit committees of four companies, including Oak Industries Inc. and Federal-Mogul Corp.: “After all these years, you would have thought Lockheed would have gotten it right. Nobody in good conscience could possibly think that the former CFO, particularly if he’s paid as a consultant, constitutes an independent director. It’s not good corporate practice. It’s bizarre.”

Lockheed Martin spokesman Lee Whitney counters that it was “entirely proper” for Marafino to have served on the company’s audit committee, adding that the former CFO has “an unassailable reputation for integrity.” Marafino’s planned retirement from the board was disclosed in March.

The SEC on the Attack

Like his predecessor, current SEC chairman Arthur Levitt is vigorously pursuing companies that practice aggressive earnings management, and turning his attention to the role audit committees play. As part of Levitt’s ongoing assault on accounting irregularities, audit committees have come under intense scrutiny for not providing the independent oversight of a company’s financial controls and reports that investors expect.

“This is an area that cries out for adjustment,” Levitt groused at a press briefing last fall, noting his concern about audit committees that hold only a few meetings a year, conduct brief and perfunctory reviews of financial statements, and include members who are unqualified or too close to management.

In turn, in February, a blue-ribbon panel of market regulators, accounting officials, and corporate executives–assembled in response to Levitt’s concerns–proposed a new set of listing requirements and disclosure rules to strengthen audit committees. The 10 recommendations not only spell out a revised definition of what makes for an independent and qualified audit-committee member, but also detail new responsibilities for audit-panel members, as well as new steps for monitoring the work of the company’s external auditor.

While the recommendations are still subject to approval by the SEC and other regulators, they at least set the floor for what is expected from audit committees. And some see them as a necessary deterrent. “It does seem logical and rational,” says SEC general counsel Harvey J. Goldschmid, “that an effective audit [committee] process will mitigate, not eliminate, the kinds of venal accounting-fraud situations we’ve seen and, more important, would increase the probability that quality disclosure will take place.”

Indeed, in retrospect, it’s clear that some of the companies with recent accounting disasters have had dubious audit committees. All four members of the special audit panel investigating the massive fraud at Cendant Corp. had personal and financial ties to the company. The audit committee at Waste Management Inc., which was dominated by the company’s former CFO, failed to review the auditor’s management letter during the years that the company racked up $3.5 billion in special charges that were eventually reversed. And even though the Sunbeam Corp. board ousted CEO Al Dunlap last June, the troubled company’s audit committee reported only two meetings during the fiscal year in which, it turned out, Sunbeam was artificially inflating revenues.

But critics of Levitt’s plan say that these egregious cases do not reflect audit committees in general. Instead, they charge that Levitt’s agenda is tantamount to overkill. “The failure of audit committees is not that frequent,” says Rick Swanson, executive director of the Institute of Management Accountants, in Montvale, New Jersey. “The rules in place are not in need of a lot of tinkering.”

Others wonder if having more responsibilities will detract from audit committee effectiveness, rather than enhance it. “I’m not persuaded that more processes and more certifications will improve the quality of audit committees,” says John Olson, an attorney at Washington, D.C., law firm Gibson, Dunn & Crutcher LLP. “There may be so many chores that they [won’t be able to] do the big things right.”

Moreover, says former Secretary of Commerce Barbara Hackman Franklin, who serves on four audit panels and heads two, the fear of being sued will increase, and many directors may be less inclined to be on the committee. “Many people on boards already don’t want to serve on audit committees,” she says, “and if more liability accrues, we will have a harder time getting people to serve.”

Stirring a Backwater

To better gauge the current state of audit committee practices and how they might be affected by the SEC’s recommendations, CFO recently reviewed the disclosures in 150 corporate proxies filed in 1998. We picked companies from a variety of sources, and compiled information on the number of meetings, the committee-members’ occupations, and director compensation. Further, we tried to assess which members had conflicts that might compromise their independence.

What we found was that audit committees today meet an average of 3.28 times annually, which suggests that the typical panel may not review the quarterly financial statements as the blue-ribbon committee has recommended it do. We also found that 26 percent of companies in our survey had at least one audit member who would not meet current stock-exchange standards for independence, and only 22 percent had someone with an explicit finance or accounting background. Some of these tallies were almost identical to those in a December survey of 550 companies by the American Society of Corporate Secretaries.

The findings don’t surprise many corporate-governance experts. “If we’ve learned anything lately, it’s that we can’t count on audit committees,” says Nell Minow, a principal at LENS Inc., a shareholder advisory firm in Washington, D.C., who reviewed the CFO research. “They’re not up to the job.” Slightly more positive is A.A. Sommer Jr., chairman of the Public Oversight Board and of a group organized by the National Association of Corporate Directors (NACD) to develop yet another report on audit committee best practices. “Some are good, some are bad, some are indifferent,” Sommer says. “But we need to find a way to make them all perform better.”

Finance Illiteracy

Long a backwater of corporate boards, and often packed with celebrities and associates of the CEO, the audit committee has typically been the place to stow new directors so they can learn about the business. Frequently lacking any background in finance and accounting, these directors are rarely in a position to challenge management or external auditors.

In a speech last year, Levitt described such audit committee members as “thoroughly unqualified,” citing one company with a professor, a politician, and an engineer on its committee, and another with a teacher, a nurse, and a nonprofit executive. “There’s nothing wrong with those professions,” Levitt said, “but audit committees really represent the watchdog for a corporation.”

In our review of 150 proxies, we found a fair share of politicians, lawyers, and educators, as well as a few unexpected occupations represented among the total of 568 audit committee members named. There was a winery owner on the Lone Star Steakhouse & Saloon Inc. audit committee and a talent agent on Oracle Corp.’s. Perhaps the most unlikely audit committee was MBNA Corp.’s. The huge credit-card provider has a doctor, an English professor, and a former U.S. Attorney General providing financial accountability. MBNA’s director of investor relations, Brian Dalphon, notes that the doctor and professor have been on the board since 1991. “They have a lot of experience,” he says, “and that’s why they’re on the audit committee.”

Far and away the most common occupation among those who serve on audit committees is CEO, with 34.5 percent of members in our survey either current or retired chief executives. All six members of the Goodyear Tire & Rubber Co. audit committee fit that bill. Other executive officers are well represented on audit committees, too, though not CFOs. Only 19 of the 150 companies have finance chiefs from other companies as committee members (5 others have their own current or former CFO on the audit panel). Nine more companies have individuals with an explicit finance or accounting background, for a total of 22 percent of the businesses surveyed.

“There was much less finance and accounting expertise than I expected,” says Minow. “I was flabbergasted that there were so many firms that had no one with finance expertise. It should be 60 to 75 percent.”

As it turns out, the blue-ribbon panel’s recommendations are not likely to do much to increase audit committee representation among people with strong finance skills. The notion of spelling out member qualifications proved to be a difficult sell. Initially, in fact, the panel rejected a proposal that at least one member should be trained and have worked in finance and accounting. Instead, it set broad standards for financial literacy among audit members, and the final recommendation counts a CEO or other senior officer with financial-oversight responsibilities as being financially literate.

“Financial expertise got watered down,” says Frank Borelli, CFO of Marsh & McLennan Cos. and the only current CFO on the blue-ribbon panel. The recommendation is “not going to cause a lot of change,” he concedes, “but perhaps it will open people’s eyes.”

Appearance Is Reality

The panel has already opened a few eyes with its stance on independence. It proposed to disqualify directors from audit committees who are relatives of management, are paid directly for work other than board service, hold senior positions in firms with business ties to the company, or were employed by the company within the previous five years.

That would disqualify audit committee members at 34 companies in the CFO review. Yet many corporate-governance experts say the SEC didn’t go far enough. Says John M. Nash, vice chair of the Center for Board Leadership, a corporate-governance think tank in Washington, D.C.: “I have a rigid definition of independence: An independent director has no relationship with the company other than as a director–no personal or business ties–and never as an employee.” By Nash’s standards, another 17 shouldn’t have been on the audit committee.

Not that companies are eager to comply with the SEC’s proposed dictates. Southwest Airlines has on its audit committee two outside attorneys, C. Webb Crockett and Travis Johnson, but CFO Gary Kelly describes their legal work for the company as “quite immaterial.” Adds Kelly, “We’re not looking at [making] any changes [to our audit committee].”

Likewise, Steven Schneider, the senior vice president, finance, of apparel retailer The Finish Line Inc., in Indianapolis, argues that audit member Jonathan Layne is “not our main legal counsel,” but does, of all things, SEC work for the company and “would be engaged if the SEC investigated us.” Schneider also doesn’t mind that The Finish Line’s audit committee includes founder and CEO Alan Cohen, whose brother Gary is general counsel.

“If anything, Alan is extremely open. He wants to hear problems. That has never been an issue for us,” Schneider says. “If I were him, I’d want to be on the audit committee. Not to sway other members, but to say, ‘This is my company.’”

Shareholder activists also have plenty to say about the blue-ribbon panel’s decision to exempt businesses with a market capitalization under $200 million from these new rules for independence. “This is a whopping loophole that makes no sense at all,” Minow protests. “There’s more volatility, more nervousness, and more bodies buried per dollar in small-cap companies.”

SEC general counsel Goldschmid, however, defends the cutoff as “reasonable to me,” given the “practical problems” of attracting independent directors to smaller companies. Although the panel’s recommendations do not indicate what should be done about audit committees at exempted firms, Goldschmid hopes that they will “try to comply” with the requirements for larger companies.

What’s an Audit Committee to Do?

Improving the ties between the audit committee and the auditors–a relationship that, as former SEC chairman Hills puts it, “historically has never really meshed”–is a central theme of the blue-ribbon panel’s recommendations. Among the 10 proposals is a call for the outside auditors to be accountable to the audit committee, instead of to management. In addition, the audit firm would be expected to have more-detailed discussions with the audit committee about the company’s accounting practices and about the nonaudit work it does for the company. The ultimate objective is to encourage dialogue, especially outside executives’ earshot.

Big Five auditors say the biggest hindrance to such a relationship is that audit committees fail to set aside enough time to do the work necessary to be effective. Ernst & Young LLP audit partner Tom Milan says the best committees have a charter of the panel’s duties and allow plenty of time to complete all of them. The committee convenes the night before a board meeting, so it can take as much time as it needs. And after a formal presentation and discussion, it meets separately with the internal auditor, the external auditor, and management to make sure nothing goes unsaid.

Too many committees, however, hardly meet at all. Among the 150 proxies reviewed by CFO, 3Com Corp.’s audit panel met most often–11 times in one year. The period coincided with an SEC challenge of the company’s accounting practices. Conversely, the audit committees at 50 companies met just once or twice in the previous year. “I don’t think one or two meetings a year is anywhere close enough to do a thorough job, given the complexity and high level of risk,” says Dana Hermanson, director of research at the Corporate Governance Center and an accounting professor at Kennesaw (Georgia) State University, who has studied audit committees.

“We should have more, probably,” concedes James Ticehurst, the CFO of Verity Inc., whose audit committee was one of the 24 in the CFO sample that met just once last year. He adds that more meetings would be “more show than tell,” however, because the Sunnyvale, California, software firm is “squeaky clean” when it comes to its accounting.

But that kind of disclosure is exactly what the SEC wants the audit committee to hear from the auditors, and not just from management. One of the more controversial recommendations of the blue-ribbon panel calls for the audit committee to inquire about the quality of the company’s accounting principles, as well as their “acceptability” and the degree of “aggressiveness or conservatism” involved in accounting choices. The audit-directors would then have to disclose that they discussed the issue. “That will put the onus on the outside auditors,” says Marsh & McLennan’s Borelli, “and they’re a bit jumpy about that.”

Barbara Hackman Franklin says that when she has asked auditors to comment on a company’s accounting practices, they speak more freely about those that are conservative than those that are aggressive. But she expects that the SEC’s recommendations will help “smoke out aggressiveness.”

Another recommendation that will put auditors on the spot concerns having the audit committee obtain a written statement from the external auditing firm on its nonaudit and consulting assignments with the company. Again, Franklin says she has been asking for this information for several years. In one company for which she chairs the audit committee, the policy is that if the consulting fees amount to more than 50 percent of total fees on a three-year rolling average, it’s time to take a closer look. “It’s a judgment call about how much consulting is too much before the auditors’ independence is impaired,” she explains.

The major accounting firms say they welcome examination of their nonaudit relationships with their audit clients–to clear the air, if nothing else. “There’s been a lot of questioning of auditor independence lately, and whether the audit opinion is worth anything,” concedes Greg Jonas, managing director of financial assurance at Arthur Andersen LLP. “That’s not good for the auditing profession.”

Who’s Liable?

Whether additional responsibilities are good for the audit committee or whether they will simply increase directors’ liability is another growing concern. After all, says attorney Joseph Weiss, in the New York office of law firm Weiss & Yourman, “The audit committee is a natural target.” But is there really a correlation between companies with defective audit committees and companies that are targeted for accounting irregularities and shareholder lawsuits?

At the very least, plaintiff and defense attorneys alike report that when they work on fraud cases, they often find that the audit committee was asleep at the switch. “I can’t say the [accounting] problems would have gone away in situations in which there was an active audit committee,” says attorney John Olson, “but they may have been detected and tended to before litigation was filed.”

In CFO’s survey of 150 proxies, we came across 17 companies that were the subject of recently filed shareholder suits alleging some form of accounting chicanery. And in 9 of those cases, there was evidence that the audit committee either met too infrequently to be effective or had members with questionable ties to the company, while the 8 others appeared, on the surface, to be doing their jobs well.

Perhaps the most egregious example is Telxon Corp., which is under SEC investigation for overbooking revenues and was hit with shareholder litigation in February. At the Akron, Ohio, maker of wireless information systems, three of the five audit-panel members have obvious conflicts: John Cribb is a retired executive who left the company in 1995; Robert Goodman, senior partner in a Cleveland law firm, is general counsel; and Norton Rose was paid more than $300,000 for consulting services between 1996 and 1998.

Nevertheless, none of the three Telxon directors was named as a defendant in the shareholder suits filed against the company–and audit committee members rarely are in other cases. Plaintiff attorneys say the decision depends on whether an audit-director sold stock during the class period, not whether the committee practices were faulty. “Just being on the audit committee doesn’t necessarily create the inference that you know about the fraud,” says Reed Kathrein of the San Francisco law office of Milberg Weiss Bershad Hynes & Lerach LLP. “Insider selling creates the inference that you had adverse information and acted on it.”

In theory, audit committees that abide by the SEC’s proposals will be safer from litigation, though the higher standards will certainly encourage greater scrutiny by plaintiff lawyers. “The liability has always been there,” says Joseph Weiss, “but the egregious examples lately place a greater focus on the work they’re doing to give investors assurance.”

Whither Audit Committees?

For the blue-ribbon panel’s proposals to have any force, it will need a little help from its friends. The SEC must come up with new disclosure rules, the AICPA must come up with new auditing standards, and the stock exchanges must enact new listing standards. And with Arthur Levitt looking to maintain momentum for his campaign against accounting irregularities, he has indicated that he wants to see action sooner rather than later.

“He hopes that each group will act before we’re too late into the spring,” says the SEC’s Goldschmid.

Yet for all the apparent shortcomings of audit committees today, the SEC’s effort has generated concern about adding more duties than a typical audit committee can handle and setting inflexible standards that discourage committee participation. Says Rick Fleming, the executive vice president and CFO of USG Corp., a manufacturer and distributor of building materials in Chicago, who supports the effort of the blue-ribbon panel, “The recommendations are getting a lot of review, and some will be subject to a lot of public comment–not because of the theory involved, but because of the practicality of some of them.”

Even more unsettling is the question of whether the audit committee will soon find itself in a watchdog position it can’t fulfill. Rather than blunt accounting trickery and curtail fraud, the current push to improve committee effectiveness could simply raise expectations higher than is warranted.

“The fear is that we create an expectations gap,” observes attorney Olson. “Audit committees don’t audit the books. The best they can do is make sure the best possible systems are in place.”

Likewise, Charles Elson, a law professor at Stetson University, in St. Petersburg, Florida, and a corporate-governance expert, worries that the audit committee will be seen as a panacea for improper financial reporting in this age of accounting irregularities. “I don’t believe it is, and I don’t believe it was designed to be,” he argues. “If you think the audit committee is there to guarantee the efficacy of management’s accounting acumen, then you’re barking up the wrong tree.”

As for the Center for Board Leadership/NACD’s blue-ribbon panel on audit committees, it expects to call for even tougher standards in a report to be released in June. John Nash, who is coordinating that work, suggests that the group probably will be even stricter about what makes an audit-director independent, and may call for the board’s nominating committee to control the process of selecting new audit committee members so that the CEO has less sway.

But adding another report to the pile won’t tell you much about whether audit committees are changing for the better.

Just keep your eyes on Lockheed Martin.

Stephen Barr is senior contributing editor of CFO.

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Are They Worth More?

The recommendations of the blue-ribbon panel will mean added work for audit committees, as well as a greater risk of being sued. That has some people wondering whether audit committee members should be paid more than other directors. “Will we have to change the compensation upwards?” asks audit committee veteran Barbara Hackman Franklin.

In the meantime, committee members are paid the same as other directors, and the trend has been toward greater amounts of stock compensation. Some companies pay a portion of a director’s annual retainer in stock, while many more grant either stock or stock options on top of cash payments for board membership and meeting attendance.

“We recommend that companies pay directors all in stock and set stock-ownership guidelines,” says John M. Nash of the Center for Board Leadership.

Among the 150 proxies reviewed by CFO, only 1 company, Alcoa Inc., paid directors in cash only (the $85,000 retainer was also the largest in the sample), while 17 companies paid no cash retainer. “Stock provides an incentive to do what’s best for the shareholders,” says James Ticehurst of Verity Inc., which grants only 5,000 stock options to its audit panel members. “Cash compensation would be trivial income.”

Even though any form of compensation for board service may be “trivial” for most directors, there is concern that paying in options is a touchy practice. Indeed, European companies frown on having a director own any stock, because that could compromise independence. “I see problems with options, because they are an investment,” says A.A. Sommer Jr. of the Public Oversight Board, who has served on six audit committees himself. “I’d rather have [audit committee members who are] shareholders than potential shareholders only if the stock goes up.”

Stetson University law professor Charles Elson advises companies to establish stock ownership targets for directors, something only three firms in the CFO sample do. One is Sunbeam Corp., at which Elson, who serves on the audit committee, saw his net worth tumble after the discovery of accounting irregularities last year. “I believe in stock,” he says. “Options put no money at risk. You need the downside, too.”

Although the SEC has pointed to the connection between large stock option grants to executives and the tendency to manage earnings to meet analyst expectations, the agency apparently is not fretting over such a connection involving audit committee members. The blue-ribbon panel offered no recommendations on compensation.

Frank Borelli, CFO of Marsh & McLennan Cos., says he used to believe that directors should have no equity so that they would have no temptation to influence earnings. But, more recently, he has come to believe that the value of the stock “is such a small amount relative to [the directors’] own net worth. Think of all the CEOs [on boards]. They’re multimillionaires. Would they do something for a few points on the shares?”–S.B.

How the CFO audit committee survey was done.

Current disclosures can tell only so much about the kind of job a particular audit committee is doing. What they can’t tell is what goes on behind closed doors when a company’s financial statements are reviewed. But in an effort to see how typical audit committees stack up, we looked at 150 corporate proxies filed in 1998. What we found were plenty of winners and losers when it came to what’s generally expected of audit committees.

Selected by using various lists and systems, the proxies in our sample include 24 companies from the Dow Jones 30 Industrials; 28 that garnered significant mention in the Wall Street Journal at the end of December; the 10 that were added to the Nasdaq-100 Index in December, and the 10 they replaced; every 50th Fortune 500 company (from 1998), starting with number 25; the top 20 companies on the Web 100, which rates Internet presence; Fortune’s 10 most admired companies; companies with representatives on either blue-ribbon panel; and so on.

While not scientific, the review mirrored a survey released in December of 550 companies conducted by the American Society of Corporate Secretaries that found an average of 3.25 audit committee meetings per year and 25 percent of companies with nonindependent directors.–S.B.