Important Developments Affecting Audit Committees of NYSE-Listed Companies

August 12, 2002
7 minutes

The Sarbanes-Oxley Act of 2002 (the “Act”) imposes new requirements on public company audit committees. Compliance will be required no later than April 26, 2003, after which time the NYSE will be required to delist any non-compliant company. On August 1, 2002, the New York Stock Exchange also approved new audit committee requirements, which have been submitted to the SEC for approval. It is likely that the SEC will approve many, if not all, of these proposed rules. Given the lead time needed to educate audit committees and develop compliance strategies, most companies covered by the new requirements will want to move promptly in the direction of compliance without waiting for the completion of formal rulemaking. With this in mind, this memorandum discusses the requirements of both the Act and the NYSE as they relate to audit committee composition and responsibilities and the independence of the outside auditors. The NYSE requirements are those noted as “Pending SEC Approval;”, all others are set forth in the Act.

Composition of Audit Committee:

  • An “Affiliated Person” may not serve on the audit committee (Effective no later than April 26, 2003). The term “Affiliated Person” is not defined in the Act, but is likely to include controlling or even major stockholders and their officers and representatives. NYSE rules say that a director holding 20% or more of the company’s stock (or who is a general partner, controlling shareholder or officer of such holder) cannot chair or be a voting member of the audit committee, but may serve as a non-voting member and may participate in meetings (Pending SEC approval).
  • Audit committee members may not receive any consulting or other fees other than board, audit committee or other committee fees. (Effective no later than April 26, 2003).
  • Companies must disclose whether its audit committee has at least one member who is a “financial expert.” This term was not defined by the Act, but will be defined by the SEC. The SEC must consider in its definition whether a person has, through education and experience as an auditor or a principal financial officer, comptroller or principal accounting officer of a company, an understanding of generally accepted accounting principles and financial statements, experience in the preparation of financial statements of generally comparable companies, experience with internal accounting controls, and an understanding of audit committee functions (effective no later than January 26, 2003). NYSE rules say that the audit committee chair have must accounting or related financial management expertise (pending SEC approval). Current NYSE rules require only that one member of the committee have accounting or financial management expertise.

New Audit Committee Responsibilities: Audit committees should be aware of the following new responsibilities.

  • Appointment of Independent Auditor. The audit committee is directly and solely responsible for the appointment, compensation and oversight of the company’s outside auditors (including the resolution of disagreements between management and the auditor regarding the company’s financial reporting). We are not sure that the practice, followed by some companies of seeking shareholder approval of the auditors is consistent with this requirement. Effective no later than April 26, 2003.
  • Report of Independent Auditor. The company’s independent auditor must report directly to the audit committee (Effective no later than April 26, 2003). Also effective no later than April 26, 2003, the audit committee must consider reports from the independent auditor on
    • the company’s critical accounting policies and practices;
    • all alternative treatments of financial information permitted within generally accepted accounting principles that have been discussed with management; and
    • all other material written communications between the independent auditor and the management.

      The NYSE rules (pending SEC approval) provide that the audit committee should review a report by the independent auditor at least annually describing:
    • the firm’s internal quality control procedures;
    • any material issues raised by the most recent internal quality-control review, or peer review, of the firm, or by any inquiry or investigation by governmental or professional authorities, within the preceding five years, respecting one or more independent audits carried out by the firm, and any steps taken to deal with any such issues;
    • all relationships between the independent auditor and the company.

  • Approval of Audit and Permitted Non-Audit Services. Audit services and permitted non-audit services, including tax services, must be approved in advance by the audit committee. The effective date of this provision is not clear, although it is possible that it is effective immediately. In any event, we believe companies should begin implementing this requirement immediately. There is a de minimis exception in the Act for services not recognized by the Company as non-audit services. All approved non-audit services must be disclosed in periodic reports filed with the SEC. The Committee may delegate to one or more members the authority to grant such approvals.
  • Prohibited Non-Audit Services. The Act prohibits accounting firms from providing the following non-audit related services to a company to which it provides audit services (Effective upon registration of the outside auditors with newly created Public Company Accounting Oversight Board):
    • bookkeeping or similar services;
    • financial information systems design and implementation;
    • appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
    • actuarial services;
    • internal audit outsourcing services;
    • management or human resource functions;
    • broker or dealer, investment adviser, or investment banking services;
    • legal services and expert services unrelated to the audit; and
    • any other service deemed impermissible by the newly created Public Company Accounting Oversight Board.

  • Procedures for Accounting Complaints. The audit committee must establish procedures for the receipt, retention and treatment of complaints received by the company regarding accounting, internal accounting controls or auditing matters. The audit committee must also establish procedures for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters. Effective no later than April 26, 2003.
  • Authority to Hire Counsel and Experts. The audit committee has the authority to hire independent counsel and other advisers as the committee deems necessary to carry out its duties. The audit committee shall also be given appropriate funding, as the committee deems necessary, to compensate the independent auditor and advisors employed by the Committee. Effective no later than April 26, 2003.
  • Items Required to be Reviewed by the Committee. Pending SEC approval.
    • Financial Statements. The audit committee should discuss the annual audited financial statements and quarterly financial statements with , management and the independent auditor, including the company’s disclosures under its MD&A section.
    • Press Releases and Financial Information. The audit committee should discuss earnings press releases, as well as financial information and earnings guidance provided to analysts and rating agencies.
    • Risk Assessment Policies. The audit committee should discuss policies with respect to risk assessment (company’s major financial risk exposures) and risk management.
    • Audit Problems. The audit committee should review with the independent auditor any audit problems or difficulties and management’s response to such issues.

  • Meetings with Management and Auditors. The audit committee should meet separately, at least quarterly, with management, with internal auditors, and with independent auditors. Pending SEC approval.

Outside Auditor Independence: In an attempt to preserve the independence of outside auditors, several new restrictions and requirements have been imposed.

  • Prohibition on non-audit services by independent auditors. A company’s independent auditor and any of its professional employees are prohibited from providing to the company contemporaneously with its audit any of the specified non-audit services. Effective immediately.
  • Auditor disqualification based on company personnel. An accounting firm may not provide any audit service to a company if the CEO, controller, CFO, or chief accounting officer was employed by the accounting firm and participated in any capacity in the audit of the company during the one year period preceding the initiation date of the audit. Effective upon registration of the outside auditors with newly created Public Company Accounting Oversight Board.
  • Audit partner rotation. Every five years, it is required that the lead audit partner responsible for the audit of a company and the audit partner responsible for reviewing the audit are rotated off the engagement. Effective upon registration of the outside auditors with newly created Public Company Accounting Oversight Board.
  • Rotation of outside auditor. The Comptroller General of the United States will conduct a study and review of the potential effects of requiring the mandatory rotation of registered public accounting firms. A report on this study will be presented to Congress no later than July 30, 2003. Audit committees should be aware of a potential regulation arising from this study.

Contact Information
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