November 29, 1999
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Reference: File No. S7-22-99
Proposed Rule on Audit Committee Disclosure
Dear Mr. Katz:
The substance of the recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees ("Blue Ribbon Committee") has now been incorporated in proposed rules of the New York Stock Exchange ("NYSE"), the National Association of Securities Dealers ("NASD") for companies listed on the American Stock Exchange ("AMEX") or quoted on Nasdaq, the Securities and Exchange Commission ("Commission" or the "SEC") and the American Institute of Certified Public Accountants' Auditing Standards Board ("ASB"). It is a tribute to the work of the Blue Ribbon Committee that the proposed rules are faithful to the objectives expressed in its report and that its specific recommendations represent the foundation upon which these rules have been built.
We strongly support qualified, independent audit committees and recognize that many companies, including smaller companies, have such committees. We also recognize that audit committee effectiveness and performance varies significantly and, accordingly, there was a need for the study undertaken by the Blue Ribbon Committee. We support the proposed rules of the NYSE, NASD, AMEX, SEC, and ASB taken collectively and believe they will strengthen the independence and qualifications of audit committee members and the effectiveness of audit committees.
The following are our specific comments regarding the Commission's proposed rule on audit committee disclosure.
III A. Pre-Filing Review ofWe endorse the Commission's proposed requirement for all companies to have timely ("pre-filing") reviews of interim financial statements by independent auditors. Since 1993, we have required such reviews as a condition of performing annual audits for our SEC registrant clients. Our experience with timely quarterly reviews has been good. Generally, timely quarterly reviews are a "win-win" situation for companies and their auditors as they minimize year-end problems that are interim period related. We have experienced numerous instances in which issues have been identified and addressed during the quarters, months before they would be subject to evaluation through year-end audit procedures, thereby improving the quality of interim financial reporting and avoiding potential restatements.
The mandate for timely quarterly reviews should apply to all public companies in view of the quality improvement and risk reduction benefits resulting from these reviews. Although the cost may be proportionately greater for smaller companies, the importance of these reviews for smaller companies may also be greater because they may have less depth of personnel with financial and accounting expertise.
In today's environment, the most appropriate timing for an SEC requirement to complete the quarterly reviews is before filing the Form 10-Q. We believe, however, that companies and their auditors should strive to complete such reviews and discuss their results with the audit committee or committee chair (perhaps telephonically) before the earnings release.
III B. The Audit Committee ReportThe Commission's proposal for Paragraph (a) (4) of the proposed rule would require audit committees to provide negative assurance as to material misstatements or omissions of material facts relating to the audited financial statements. We acknowledge that the SEC's proposal is an improvement over Recommendation 9 of the Blue Ribbon Committee in that it does not require audit committees to come to an affirmative conclusion about the financial statements being prepared in accordance with generally accepted accounting principles. The Commission's proposal for negative assurance is more consistent with the oversight role of audit committees.
Even though the current proposal is an improvement, we continue to have concerns about the potential for, or even the perception of, increased liability of directors serving on audit committees. An outside auditor's opinion on a company's financial statements is often a basis for allegations of liability against auditing firms. It would appear that similar allegations of liability might be asserted against audit committee members as long as their report includes assurance about the financial statements, even if it is in the form of negative assurance.
Some may believe that increasing the potential for liability of audit committee members is good, on the basis that it will cause a behavioral change and make audit committee members more diligent. If directors, however, believe that service on the audit committee may result in additional potential liability or the potential for time consuming involvement in litigation, a logical choice may be to simply avoid audit committee service. The strongest independent directors (those most able to influence a CEO or a CFO) are likely to be those with other major responsibilities and leadership positions such as in their own companies; they may well be the ones most protective of personal time commitments and most sensitive to avoiding involvement in litigation.
The Commission has proposed a "safe harbor" for the audit committee report; the effectiveness of the proposed "safe harbor" is best addressed by the legal profession. However, the actual protection afforded by the "safe harbor" might not be known until court cases testing the final rules are litigated.
We are also concerned about the potential interaction of the proposed SEC requirements for the audit committee report with the proposed requirements of the ASB for a discussion among the audit committee, management and the auditors about the quality of a company's financial reporting. Our letter of July 16, 1999 to the NYSE, NASD, SEC, and ASB sets forth our views concerning discussions about quality of financial reporting. The objective underlying our views is to improve an audit committee's understanding of a company's financial reporting, especially in terms of the significant matters, judgments and estimates affecting the financial statements. We believe that when an audit committee has an understanding of these matters, its members are in a better position to ask those "tough questions" of both management and auditors that focus on the key issues affecting a company's financial reporting.
A requirement to express negative assurance regarding material misstatements or omissions may focus the members of the audit committee and their advisors on asking "compliance based" questions and documenting support for their assertion that "nothing came to their attention" instead of achieving a thorough understanding of the financial statements based on candid discussions with management and the auditors. If the desire for protective questioning and documentation triumphs over the desire for thorough understanding, the vision of the Blue Ribbon Committee (which we share) regarding discussion about quality of financial reporting, would be diminished.
Since audit committees have responsibility for oversight of the financial reporting process, we prefer to have the audit committee reporting on the audit committee process and activities, rather than providing positive or negative assurance on the financial statements. We would also support, as an alternative, having the audit committee members report that they recommended to the board of directors that the audited financial statements be included in the company's annual report and that the directors sign Form 10-K.
If the Commission, after considering the responses to its proposed rule on audit committee disclosure, continues to believe that an audit committee report containing negative assurance is necessary, we believe that this part of the proposed rule should be delayed until its effects can be better evaluated. During this delay period, the Commission should perform a study to better determine the liability ramifications and their impact on directors' willingness to serve on audit committees. We would be pleased to assist the Commission or its staff in assembling a group of audit committee members as a forum to further discuss these issues.
III C. Audit Committee ChartersWe support the Commission's proposed rule on audit committee charter disclosures. We believe that preparing and revising the charter may enhance corporate governance between the audit committee and the board, other board committees, management, and auditors.
One of the concerns expressed about audit committee service is workload. For many if not most audit committees, the package of proposed rules is likely to result in increased work. This result is a desired outcome for those audit committees whose meetings and agendas have been too short, too scripted, and too controlled. However, companies and their boards have often assigned responsibilities to audit committees other than those contemplated by the proposed rules. Defining the responsibilities of the audit committee in its charter presents an opportunity for companies and boards to address some of the issues of audit committee workload by considering whether some non-core responsibilities may be more appropriately handled by other board committees.
Strong independent audit committees are an essential element of good corporate governance. We support the objectives expressed in the Blue Ribbon Committee report and share Chairman Levitt's vision that "there is no reason why every company ... shouldn't have an audit committee made up of the right people, doing the right things and asking the right questions." We encourage the Commission to not implement rules that may cause strong, independent directors to avoid audit committee service. In the final analysis, the right people contribute far more to the effectiveness of an audit committee than required procedures or activities.
The proposed rules of the NYSE, NASD, SEC and ASB are important to the future effectiveness of audit committees. The Commission is to be commended for setting in motion this initiative.