Questions Every Audit Committee Should Be Asking in the Wake of Enron

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® SecMail SecMail® No. 02-02-04 February 4, 2002 Questions Every Audit Committee Should Be Asking in the Wake of Enron On rare occasions, a corporate event has such a far-reaching impact that it defines the legal and regulatory atmosphere for years to come. The demise of Enron is clearly such an event, and directors in every public company – particularly audit committee members – are asking themselves what they should be considering to reduce the likelihood of becoming entangled in problems like those at Enron. With that background in mind, audit committee members should be asking – and getting clear answers to – the following questions. 1. What off-balance sheet financing does the company use? Audit committee members need to be familiar with any off-balance sheet financing mechanisms being used by the company, should be informed of their risks, and should insist on clear, understandable disclosure of those risks. While nothing is inherently troublesome about such transactions, which are permitted under GAAP, audit committees should focus on this issue, given the current environment. The SEC recently provided additional guidance concerning the disclosure of off-balance sheet arrangements, in the context of a broader statement regarding Management’s Discussion and Analysis (“MD&A”) (Release No. 34-45321, Jan. 22, 2002; http://www.sec.gov/rules/other/33-8056.htm.). 2. What related party transactions does the company engage ...

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• Publié par: Voof
• Nombre de lectures: 32
• Langue: English

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February 4, 2002 SecMail® No. 020204 Questions Every Audit Committee Should Be Asking in the Wake of Enron  Onrare occasions, a corporate event has such a farreaching impact that it defines the legal and regulatory atmosphere for years to come. The demise of Enron is clearly such an event, and directors in every public company– particularly audit committee members – are asking themselves what they should be considering to reduce the likelihood of becoming entangled in problems like those at Enron.With that background in mind, audit committee members should be asking– and getting clear answers to– the following questions. 1. Whatoffbalance sheet financing does the company use?Audit committee members need to be familiar with any off

nothing is inherently troublesome about such transactions, which are permitted under GAAP, audit committees should focus on this issue, given the current environment.The SEC recently provided additional guidance concerning the disclosure of off broader statement regarding Management’s Discussion and Analysis (“MD&A”) (Release No. 3445321, Jan. 22, 2002;http://www.sec.gov/rules/other/338056.htm.). 2. Whatrelated party transactions does the company engage in?committee Audit members should be familiar with the details of transactions with related parties.As with off sheet financing, nothing is inherently wrong with related party transactions– but they do require an adequate approval process, generally by disinterested directors, to assure their fairness, and often must be disclosed. TheSEC’s January 22, 2002 release provides additional guidance on possible MD&A disclosure of material related party transactions.(Release No. 3445321, Jan. 22, 2002; linked above.) Given the level of scrutiny that can now be expected with regard to related party transactions, directors should be comfortable that any such transactions serve the company’s best interests and are properly disclosed. 3.What relationships exist between the company and its accounting firm? Bills have been introduced in Congress that, if enacted, would have the effect of restricting or eliminating the provision o nonaudit services by a public company’s auditor.In addition, an increasing number of companies are facing shareholder proposals asking that the company’s directors limit services from the company’s auditors to only audit functions.The SEC recently declined to permit The Disney Company to exclude such a shareholderl from its annual

Division of Corporation Finance, 2001 SEC NoAct. LEXIS 849.)On February 1, Disney announced that it will no longer obtain nonaudit services from the company’s auditing firm, thus mooting the shareholder proposal. Audit committee members should review and assure that they remain comfortable with the full range of the company’s relationships with its auditor.Current SEC rules prohibit or restrict auditors from providing a range of nonaudit services to audit clients.Other nonaudit services are permitted; however, fees for both audit services and various categories of nonaudit services must be disclosed in the annual proxy statement.Some companies have concluded that the providing any nonaudit services. In our view, each company must reach its own decision as to whether, and under what circumstances, it retains its auditors to provide other services, weighing such factors as the benefits

the accounting firm's ability to perform its audits, and the accounting firm's ability to render such services at a lower cost than other service providers. Moreover, audit committees should be aware of the range of any nonaudit services that their outside auditors are rendering.Audit committees need to disclose via the annual proxy statement whether they have considered whether the provision of nonaudit services is compatible with the auditor’s independence. Finally, it is not unusual for a company’s financial reporting staff to company’s accounting firm.This phenomenon is quite natural, and can facilitate the ability of the auditor to work with the company.Indeed, current auditor independence standards contemplate that this will occur with some frequency, as there are rules that specifically address when a former partner or employee of an accounting firm may accept a position with an audit client.In the wake of Enron, however, this has become the target of some public criticism.While much of that criticism may be ill considered, audit committees would do well to understand the level of such relationships and assure that they are comfortable with the situation. 4. Whatprocess does the company have to identify and evaluate material financial risks? Risk disclosure is not a new concept for public companies, but it is certainly one that we will all be hearing much about in the months to come.The SEC has long described MD&A disclosure as the key place for discussion of the risks and uncertainties faced by the business, and a way for investors to “look at the company through the eyes of management.”The SEC has once again reiterated the importance of risk disclosure in its January 22, 2002 guidance on MD&A, cited above, (Release No. 3445321, Jan. 22, 2002, linked above.)The SEC has also indicated that its analysts in the Division of Corporation Finance will review the 10K annual report filing ofeveryFortune 500 company subject to its jurisdiction. In this environment, companies need to make sure that they have a strong process for identifying and evaluating material risks to the company’s business, and then for assuring that material risks are plainly disclosed to investors.Given the importance of this process to the company’s financial re audit committee members should be informed as to how this is being accomplished.

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5. Whatare the company’s critical accounting policies? Latein December 2001, and clearly in response to concerns raised by Enron, the SEC issued “cautionary advice” strongly encouraging

impact of those policies on reported results in their upcoming annual reports (Release No. 3445149, Dec. 12, 2001;http://www.sec.gov/rules/other/338040.htmnew rules have been adopted or even.) No section of their next annual reports. What the SEC has in mind is the “conscientious identification and assessment” of the “three, four or five most critical accounting principles upon which a company’s financial status depends, and which involve the most complex, subjective or ambiguous decisions or assessments.”(SeeSEC Chairman Pitt, “How to Prevent Future Enrons,” Wall Street Journal, Dec. 11, 2001; http://www.sec.gov/news/speech/spch530.htmaddition, the SEC would like to see “information.) In about the range of possible effects in differing applications of these principles.” The SEC’s December 12, 2001 release noted in particular the need for audit committees to engage in “proactive” discussions with company management and outside auditors regarding these key accounting judgments.Indeed, Chairman Pitt has publicly identified as a “systemic problem” revealed by the Enron crisis “audit committees that often do not understand the accounting principles employed by manage ment,or the consequences of using different principles or different assumptions.”(Remarks at the 29th Annual Securities Regulation Institute, Jan 23, 2002; http://www.sec.gov/news/speech/spch536.htm.) AsChairman Pitt has indicated, “audit committees must understand why critical accounting principles were chosen, how they were applied, and have a basis for believing the end result fairly presents their company’s actual status.” Audit committees should promptly discuss with their advisors how they will approach this task. Audit committees may wish to engage in a direct dialogue with auditors outside the presence o management and probe whether, in the views of the auditors, the application ofthe critical policies by management reflects a conservative or aggressive approach, or entails a particularly high degree o subjectivity. Finally,it is not enough to perform these tasks – committees should make sure their efforts are well documented. 6. DoI have confidence in the company’s key management and auditing personnel? Beyond any financial analysis, audit committees should not lose sight of the enormous importance of the integrity of company management and the auditing personnel assigned to the company’s account.Even the best system of safeguards can be subverted by people who will place their own personal desires above the fundamental values of honesty and integrity. While no objective test that can determine the personal integrity of someone placed in a position of trust, every audit committee member should have a sense of confidence in the personal integrity of key management and auditing personnel.As representatives of the company’s shareholders, every director should demand nothing less. 7. Isthe Audit Committee process in order? Latein 1999, the SEC, the NYSE, the and their need for a charter that must be reevaluatedrticularl

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developments, audit committees should reassure themselves that they meet all applicable regulatory requirements, that their charters remain adequate to meet their responsibilities, and that they perform (and document their performance of) the duties set forth in their charter. Matt T. Morley,Washington, DC Richard A. Steinwurtzel,Washington, DC Karl A. Groskaufmanis,Washington, DC Dixie L. Johnson,Washington, DC Paul H. Pashkoff,Washington, DC February 4, 2002 [e-mail] SecMail® is published by the Securities Regulation, Compliance and Enforcement Group of, and is a registered trademark and servicemark of Fried, Frank, Harris, Shriver & Jacobson. SecMail® is provided free of charge to subscribers. If you wouldlike to subscribe to this Email service, please send an Email message [e-mail] andinclude your name, title, organization or company, mail address, telephone and fax numbers, and Email address. To view copies of previous SecMails, please visit our SecMail® archives at http://www.ffhsj.com/secreg/secarch.php3 To view copies of previous Securities To Our Client Memoranda, please visit our archivesat http://www.ffhsj.com/cmemos.php3?topic=Securities+Regulation%2C+Compliance+and+Enforcement.

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