Dr Barry Jay Epstein

Dr Barry Jay Epstein, Accounting Expert at Epstein + Nach LLC

Management fraud and auditor failure to find that fraud have received the greatest share of attention to date; and relatively less attention has been directed at the role of audit committees in these financial reporting failures. The current cycle of financial reporting scandals has already caused further attention to be given to the issue of corporate governance, including the vital role of audit committees, but actual implementation of meaningful changes has lagged. Audit committees serve as a key bulwark for ensuring the integrity of the financial reporting process, so it is to be expected that they will soon be subjected to greater scrutiny and to higher performance expectations by investors and regulators. Executing a comprehensive program, which includes the following five points, will provide boards of directors and their audit committee members with the tools they need to appropriately discharge their duties. In the long run, such efforts will help restore the investor confidence that is so vital to the workings of our economic system.

1. Consult With An Independent Accounting Advisor

Audit committees should consult with an independent accounting advisor. Audit committees members have the right to seek both legal and financial reporting assistance, to be compensated by the reporting entity, and exercise of this right can vastly improve their ability to fulfill their fiduciary responsibilities. An accounting advisor would be of significant value, in terms of both appearance and substance, in rebuilding public trust and confidence in the integrity of financial reporting systems and processes.

Many, if not most, audit committees should seek assistance on matters of: (1) its financial literacy and the financial expertise requirements under the rules of the exchanges and the Sarbanes-Oxley Act; (2) the content of the audit committee report presented in the annual proxy statement, addressing the committee’s findings from execution of its financial reporting oversight responsibilities; and (3) the audit committee’s discussions with the independent auditors about the auditors’ judgments regarding the qualitative characteristics of financial reporting and accounting information.

2. Obtain Industry Specific Training

Audit committees should obtain tailored industry specific training. Through such programs audit committee members would be able to enhance their understanding of polices and practices of their company and its industry. The ability to ask penetrating questions about accounting and financial reporting matters and to evaluate the answers is critical. This would enable audit committee members to develop the self-assurance needed to challenge management and outside auditor decisions on accounting and reporting choices they have made. These training sessions would also keep audit committee members abreast of current developments in accounting and corporate finance that could affect the company’s operations and financial reporting.

3. Assess Financial Reporting Quality

Audit committees should have a formal assessment conducted of their company’s quality of financial reporting. This would enable audit committee members to gage the company’s financial reporting performance against entity-specific beliefs. The following information attributes have been generally acknowledged as being important, but have rarely been implemented as value-drivers. This is principally because of their qualitative nature, making the process of measurement challenging. Through the use of non-metric scaling and other techniques it can be determined the relative extent to which ‘trade offs’ among these attributes are condoned. The non-qualitative attributes underlying the company’s reporting quality that should be diagnosed include:

  • Relevance – Information is useful and provided in a timely manner thereby allowing the user to make informed and fact-based decisions. The constituent aspects of relevance are:
  • Timeliness – Information is available to the user before it becomes irrelevant to decision-making.
  • Predictive value – Information permits the user to evaluate the likely levels of recurring earnings and assess opportunities and risks within individual business units or geographic areas.
  • Reliability – Information is a verifiable and faithful representation of transactions and events. The components of reliability are:
  • Measurability – Information permits reasonably consistent interpretation by knowledgeable third parities.
  • Completeness – Information identifies and presents all aspects of events and transactions that could alter the users’ conclusions.
  • Neutrality – Information is free from bias.
  • Comparability – Information is prepared and presented in a manner that allows informed comparison to other periods of time and to other companies.
  • Understandability – The information is presented in an organised and coherent fashion without jargon or boilerplate language.

4. Conduct a Peer Group Comparison

Audit committees should have a comparison performed between the entity and its industry peers. Audit committee members ability to meaningfully question management and outside accountants is heavily reliant upon access to valid, current information about changes in key financial statement indicators. This information is enhanced in utility when placed in the context of analogous data from industry peers and other relevant entities.

Audit committee members would greatly benefit from gaining insight regarding matters such as relationships between financial statement items that have, e.g., changed either suddenly or over time; that differ significantly from those of the company’s peers; or that exist or are absent contrary to expectations. Taken together these may be indicia of matters such as declining liquidity, increasing leverage, or inadequate cash flow. Audit committee members should be able to identify these issues and, where appropriate, question both the underlying management decisions that may have contributed to the situation, and more importantly, the reporting and disclosures for these matters.

5. Evaluate Processes for Reviewing Financial Information

Audit committees should have an evaluation performed on the processes for reviewing financial information. Audit committee members need to become aware of weak reporting or disclosure practices that could needlessly impair the company’s reputation for forthright behaviour and financial reporting. Particularly under current market conditions, transparency in financial reporting is to be highly prized. An educated and empowered audit committee can help effectuate transparency in financial reporting so that, when there are no substantive issues to tarnish the company’s reputation, the risk of unfair guilt by association, e.g., with companies employing aggressive accounting practices, can be averted.

This evaluation should encompass ways in which the entity can improve their internal processes so problems can be avoided. Matters such as the timing and extent of the pre-issuance review of press releases, materials for investor briefings, annual and interim financial statements, and other statutory filings should be examined. Only then will the audit committee be able to judge the magnitude of risks arising from disclosure matters and the company’s history and experience regarding accuracy and completeness of financial reports.

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