No fireworks went off to herald the effective date of the Securities and Exchange Commission’s new rules for corporate audit committees. Nevertheless, June 14 marks a new era in financial disclosure—one that involves rigorous reporting and has the potential to bring more lawsuits.
As of this date, public companies should have met the requirements of the SEC’s Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (BRC). Failure to meet the requirements could result in suspended trading on the New York Stock Exchange, the American Stock Exchange, and the Nasdaq, the three major exchanges that adopted the rules along with the SEC.
The BRC’s new rules for corporate audit committees emphasize what SEC chief accountant Lynn Turner calls “the Three Ds:” due diligence and documentation.
The new rules call for at least three members on the audit committee who are financially literate, and one member who has accounting credentials, such as a CPA, a finance professor, or a CFO.
Diligent reporting will also be expected. Before the new rules, explanation of the audit committee on a company’s proxy statements amounted to little more than “asterisks next to names,” says Barry Epstein, a partner at Chicago accounting firm Gleeson Sklar, Sawyer & Cumpata LLP. Now, audit committee members must be listed separately, with credentials. The committee must also submit a statement of its activities, indicating its involvement in the monitoring of accounting practices.
The new emphasis on due diligence also calls for a constant dialogue on accounting practices between management and the audit committee.
“The committee will be asking questions like, ‘In choosing accounting principles, are you leaning toward being aggressive or conservative?’ or, ‘Why are you consistently insisting on being as aggressive as possible in interpreting accounting principles?’” says Epstein. The desired result of such diligence is to avoid the recent high-profile troubles of companies such as Xerox Corp., Cendant Corp., and MicroStrategy Inc. “Once you know you’re being watched, you don’t steal,” adds Epstein.
But there is a drawback to the increased focus on audit committee members’ financial literacy, accounting expertise, and due diligence. Epstein, who specializes in fraud and accounting malpractice, believes companies can expect a rise in shareholder class-action lawsuits. For example, “if a company’s stock takes a dive, investors naturally ask, ‘When did management know about this? When did outside directors know?’” he says. With the new rules in place, investors will have even more reason to make directors accountable.
The increased risk falls not only on the company, but also on the directors themselves, who, as independent directors, can be sued individually. For this reason, Epstein expects that many directors will seek their own counsel, in the form of lawyers or accountants, to supplement their own expertise as committee members.
In short, the once-nominal position of audit committee member is now a real job, and companies that haven’t already selected their audit committee members may find it no easy task to identify qualified candidates. “Who’s going to want this job?” asks Epstein. “You’re going to have to perform, and you’re going to be held accountable.”
Indeed, Ted Jadick, co-chairman of the worldwide corporate board practice of executive search firm Heidrick & Struggles, says that the firm has already received a number of requests for audit committee members. “With the short supply of sitting CEOs, there is a strong demand for financial types who would, among other things, take on the role of chairman of the audit committee.” He adds that it’s too early to tell, but he expects requests to go up.
Once companies have appointed their audit committee members, the final step in complying with the new rules is to continually keep them informed. “Make sure you now take steps to educate the committee members,” says Epstein. Many companies are even hiring accounting professors to put on a seminar for the audit committee to keep them on top of nuances in GAAP. Adds Epstein: “You can’t just send them a package of material to read on the plane on the way to the quarterly meeting.”