A Three-Step Plan for CFOs

How to help your audit committee work more effectively.
Robert PozenApril 1, 2011

The latest news about the Lehman Brothers audit committee is startling — that they appeared to hew to the letter of the law but missed the fact that one of the firm’s UK subsidiaries may have been engaged in quarter-end accounting shenanigans. This is just the most recent illustration of how overwhelming the audit committee’s task can be. While Lehman’s audit committee was independent and the audit process followed Sarbanes-Oxley rules, the audit-committee members appear to have been unaware that these questionable transactions were taking place.

That is, unfortunately, quite common. Members of the audit committee are deluged with massive amounts of complex information — detailed accounting notes, lengthy Securities and Exchange Commission filings, and carefully worded auditor opinions. It is extremely difficult to pick out from this mass of data the key judgments made by management and the external auditors.

CFOs can play a valuable role in making audit committees more effective by helping them deal with the data deluge, in part by providing them with better briefing binders.

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First, the binder should describe any set of transactions — such as sales and repurchases or tax-motivated deals — that occur repeatedly at the end of quarters or financial years. It is quite reasonable to design one complex transaction in response to a unique set of circumstances; it is more suspicious if similar transactions occur frequently near the end of a reporting period.

Second, the binder should identify any material item where the accounting literature allows alternative methods of presentation and explain why the company believes its alternative is preferred.

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Third, and perhaps most important, the binder should explain the rationale for any material differences in significant accounting policies between the company and its four or five main competitors. This comparative analysis should cover policies such as revenue recognition, warranty obligations, tax reserves, and valuation of goodwill or other intangibles.

All of these pieces of information should be sent to the audit committee at least one week before the committee meets. During that week, the chairman of the audit committee should informally discuss with the CFO any specific issues and “close calls” in the financial reports.

In addition, the CFO should periodically invite a thoughtful investment analyst to give the committee his or her views on the quality of the company’s financial statements. Analysts are quick to point out what they perceive as accounting gimmicks.

All of these steps can foster a more candid and trusting relationship between the CFO and the audit committee’s members, while also helping to ensure that investors have an accurate and complete picture of the company’s financial situation.

Robert Pozen is chairman emeritus of MFS Investment Management, a senior lecturer at Harvard Business School, and co-author of The Fund Business: How Your Money Is Managed (Wiley, 2011).

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