Editor’s Note: NACD’s Blue Ribbon Commission on the Audit Committee was cochaired by Dennis R. Beresford, who in addition to his professorship at the University of Georgia, serves on the boards of Fannie Mae, Kimberly Clark and Legg Mason, and Michele Hooper, co-founder and managing partner of The Directors Council, whose current board service includes Astra- Zeneca, PPG Industries, UnitedHealth Group and Warner Music Group. Beresford and Hooper wrote this introduction to the following excerpt from the Commission’s report, which focuses on how audit committee members should set the agenda to make the most of meetings.
Effective oversight of financial reporting— even in times of growth and relative calm—is no simple matter for an audit committee. Add in a global financial crisis, economic recession and uncertainty, sweeping regulatory reforms and unprecedented expectations by investors and regulators for transparency and accountability, and you have one of the most demanding, challenging—and vital—roles in Corporate America.
It’s not a stretch to say that the financial and economic crisis and ensuing volatility and uncertainty in the United States and global markets have put audit committees, and the financial-reporting systems they oversee, through a gauntlet. To be sure, some were well prepared— likely buoyed by systems and processes put into place following the Sarbanes- Oxley Act of 2002. Others were less prepared— and the crises exposed critical gaps in their financial-reporting systems, oversight processes or both.
Investors’ and regulators’ expectations of audit committees have always been high; but the demands and challenges facing audit committees have perhaps never been greater: complex accounting rules and regulations, innovative financial instruments, the global nature of businesses, product innovation, pressures on companies to meet expectations and stay competitive— there is little that doesn’t impact a company’s financials. And, as one seasoned audit committee chair often reminds us: If it’s complicated and requires a lot of time and detailed focus, it usually lands on the audit committee’s plate.
This paper is not intended to be a comprehensive manual or treatise on the duties and responsibilities of the audit committee (which is readily available from numerous sources today). Rather, drawing on the experiences and insights of our Blue Ribbon Commission members, as well as the thoughtful work and writings of others in the business, audit and governance arenas, including the NACD National Audit Committee Chair Forum, it is intended to offer practical perspectives, suggestions and leading practices on what makes an audit committee effective.
No single approach will work best for every audit committee, but we believe the perspectives and leading practices outlined in this report (including ten guiding principles) will help audit committees and boards—as well as auditors, managers and others—drive the financial-reporting process to provide investors, regulators and the market with a clear and accurate picture of the company’s performance, risks and prospects.
Setting the Agenda: Making the Most of Audit Committee Meetings
Ensuring that the audit committee’s agenda appropriately addresses the issues that require the audit committee’s attention and keeps the committee focused on its primary oversight responsibilities can be a major challenge.
Given the scope of the audit committee’s responsibilities, we recommend that at the beginning of each year, the committee create a formal responsibilities checklist and calendar for the coming year, including a tentative calendar for each audit committee meeting throughout the year. The responsibilities checklist and calendar should be based on the audit committee’s charter. [A model audit-committee charter, with tentative agendas for the year, is included in the Commission’s full report.]
The tentative agenda for each audit committee meeting throughout the year is typically crowded with key oversight topics—such as the company’s financial reports and disclosures, the control environment, risks, audit processes, whistleblower complaints and legal and regulatory compliance—as well as numerous mandatory compliance activities.
In preparation for each audit committee meeting, the challenge for the audit committee chair is to prepare a focused (yet flexible) agenda, which devotes sufficient time to the company’s key financial-reporting risks, as well as other items that require the audit committee’s attention. Audit committees must be proactive in setting their agendas—with input from management and internal and external auditors—and must not simply react to an agenda proposed by management.
To accomplish this, audit committee chairs employ a number of leading practices in developing the agenda for each audit committee meeting, including the following:
- In preparing the agenda, the chair will allocate sufficient agenda time to address what’s important, and then address the required items (not vice versa).
- The initial draft of the agenda will often be prepared by someone in management who serves as the audit committee’s primary support, such as the CFO, controller, CAE, corporate secretary, etc.
- The audit committee chair will take responsibility for finalizing the agenda and, distributing a draft agenda, if there is sufficient time, to members of the audit committee for their input.
It’s important to discuss the agenda with the CFO, the audit engagement partner, the CAE, the general counsel—and perhaps others—to obtain their suggestions on key issues and topics for the agenda, including the time allotted to each item and who should participate in the discussion of each topic. In sequencing the agenda, the most important items should be covered first; however, avoid having the same items at the end of the agenda, as it may be perceived as a lack of interest on the committee’s part.
Of course, audit committee members should be encouraged to suggest agenda and follow-up items for future committee meetings.
In order to devote more meeting time to important issues and risks, some audit committee chairs separately identify agenda items that are appropriate for a “consent agenda”—i.e., items that are routine and do not require discussion—so that the committee can approve the items without discussion, assuming all committee members agree.
Some audit committee chairs also set aside time at each meeting (or at least periodically) for the audit committee to take a “deep dive” into an important accounting judgment or estimate, or a significant accounting development that is affecting the company. Some also make it a point to have operating management discuss selected agenda items, such as key areas of risk.
In finalizing the agenda, the audit committee chair should ensure that the agenda devotes sufficient time to the company’s key financial-reporting risks. At the same time, the chair should ensure that the audit committee does not take on too much beyond its core responsibilities. If mission creep occurs, the chair may need to discuss with the chairman of the board or the chair of the nominating/governance committee the possibility of shifting certain oversight responsibilities to another committee or to a new committee.
Making the Most of Meetings
The frequency of audit committee meetings will vary from company to company, with most committees holding four to six “in person” meetings each year, as well as teleconferences as required. Typically, the audit committee will meet, often by phone, prior to the filing of the company’s 10-Qs and 10-K to discuss the reports.
The productivity and effectiveness of audit committee meetings hinges in large measure on the diligent preparation and participation of each member, as well as on the dynamics between committee members and other participants in the meeting. The audit committee chair is responsible for ensuring the efficient use of meeting time and that each agenda item receives appropriate attention. Again, audit committee chairs employ a number of practices to accomplish this, including:
- Working with appropriate management to ensure the quality of premeeting materials—for example, ensuring that the pre-meeting materials are at a level of detail appropriate for committee members (and not simply materials prepared for management and now passed along to the audit committee).
- Asking that copies of all “presentations” and other materials to be covered during the committee meeting be distributed with other pre-meeting materials well in advance of the meeting. To allow sufficient time for discussion, the chair often instructs management to assume that all audit committee members (and others, as appropriate) have read all presentations and other pre-meeting materials, and to limit their “presentation” to an overview of the most significant issues of interest and relevance to the committee.
- Setting aside time at the beginning of each committee meeting for members to have one last look at the agenda (including the amount of time allocated to each item on the agenda) after members have had an opportunity to review the premeeting materials.
- Concluding—and sometimes beginning— each audit committee meeting with an executive session so that members of the committee have an opportunity to discuss important matters privately.
We note that some audit committees routinely have informal “between meeting updates” on issues and developments, typically by email or conference calls. These updates—in which committee members participate on a “voluntary” or time permitting basis—help streamline committee meetings, as members are more current on the issues.
Executive Sessions
Candor and unvarnished viewpoints are tremendously important to the audit committee in its oversight role, which is why executive sessions are now standard fare for audit committees. As stated in the NYSE corporate governance rules, executive sessions serve as a “check on management” by promoting open discussion among the audit committee members without members of management present, and by providing an opportunity for the audit committee to have private conversations with members of management, and with the CAE and external auditors.
We offer the following suggestions for making the most of audit-committee executive sessions:
- The NYSE corporate governance rules require the audit committee to hold periodic, private sessions with management, external auditors and the CAE, and a portion of the executive session should be devoted to these sessions. Many audit committees have private one-on-one sessions at each audit committee meeting with the CFO, the CAE and the audit engagement partner. They also have periodic (once or twice a year), private one-on-one sessions with others, such as the CEO, general counsel and compliance and risk officers. Some audit committees make it a point also to have periodic private sessions with managers below the CFO level, to assess whether information the committee receives is open and transparent, and not “overly controlled” by senior management.
- When meeting one-on-one with management and external and internal auditors, audit committee members generally pose questions to elicit any concerns about management or auditor competency, resources or candor, as well as general concerns about the financial-reporting and control environment or specific accounting and control issues. At times, the audit committee chair may provide managers and auditors with a question in advance, so they have an opportunity to consider the issue more fully before the session (this should not be a “gotcha” exercise). Of course, audit committee members need to be prepared to ask follow-up questions, “test the answers” and take action to address any issues or concerns.
- Avoid negative inferences about the calling of executive sessions by holding them, as a matter of routine, at all audit committee meetings. These sessions might last several minutes or much longer; the key is to ensure discussions are not rushed or inhibited by artificial time constraints —and committee members should plan their schedules accordingly.
- An “audit committee members only” portion of the executive session provides an opportunity to privately discuss the performance of the financial- management team, including the adequacy of communications from the team, as well as compensation, succession planning, any issues or concerns that may have surfaced during the audit committee meeting and the audit committee’s own effectiveness and efficiency. It also provides an opportunity for audit committee members to deliberate and reach a consensus on difficult issues.
- It’s generally left to the audit committee chair to communicate with management or auditors regarding any issues or concerns that were identified during the executive session that may require their attention and follow-through. In addition, the chair should report to the lead director or board, as appropriate.
Get to Know Finance, Internal Audit Teams
Audit committee meetings provide an opportunity for audit committee members to get to know (and understand the potential of) members of the internal audit team and the entire finance team—whether the treasurer, tax director, chief accounting officer, controller, et al.—as well as managers a level or two below these C-level executives. At the same time, however, it is important to recognize that it is difficult to give the audit committee exposure to these key individuals without having committee meetings become unnecessarily large.
To this end, the audit committee chair should work with financial management to develop a systematic approach to providing key members of the finance and internal audit teams with appropriate, periodic exposure to the audit committee, while at the same time ensuring that there is a clear purpose for their presence at the committee meeting.
Reports to the Board, Meeting Minutes
The NYSE corporate governance rules require the audit committee to report regularly to the board of directors, and the commentary states that: “The audit committee should review with the full board any issues that arise with respect to the quality and integrity of the company’s financial statements, the company’s compliance with legal or regulatory requirements, the performance and independence of the company’s independent auditors and the performance of the internal audit function.”
For many boards, the audit committee’s report to the full board is the primary method of informing the board of the audit committee’s activities and ensuring proper coordination of the audit committee’s activities with other committees of the board.
Typically, the audit committee chair has 15 to 20 minutes on the board agenda to present the committee’s report, including time for director discussion and questions. The challenge is to update directors on the audit committee’s work, including significant issues and recommendations, and enable directors to focus on key items, engage in discussion and ask questions—in short, to keep all board members informed about the committee’s work.
While minutes of committee meetings are critical to document the processes the committee followed in carrying out its oversight responsibilities, there is an ongoing debate as to how much detail should be included in the minutes. It is critical that audit committees obtain the advice of counsel regarding the content and level of detail that is appropriate. Minutes of audit committee meetings should be distributed to the full board on a timely basis.
Ten principles to help guide audit committees—and the management and audit professionals supporting them—in their oversight of the financial-reporting process:
- Be proactive in focusing the agenda on what’s important—financial-reporting risk— and make the most of audit committee meetings.
- Insist on transparency, both external and internal—among the audit committee, management and internal and external auditors.
- Focus closely on external financial communications—beyond the 10-K and 10-Q.
- Question the continuing validity of key assumptions that underlie critical accounting judgments and estimates and be up-to-speed on key financial-reporting issues and developments affecting the company.
- Assess the audit committee’s role in the oversight of risk management—with an eye to clarifying the scope.
- Set and manage clear expectations for external and internal auditors.
- Make sure the chief financial officer (CFO) and the entire finance organization, as well as internal audit, have what they need to succeed, and be sensitive to the strains on these organizations.
- Assess the tone at the top and throughout the organization, including the effectiveness of compliance and anti-fraud programs.
- Help link change and risk management— and monitor critical alignments (controls, risks, etc.)
- Take a hard look at the audit committee’s effectiveness—including its composition and leadership—and find ways to continuously improve.
Commission Members (directorships in italics)
Co-Chairs
Dennis R. Beresford* – University of Georgia; Fannie Mae; Kimberly Clark; Legg Mason, Inc.
Michele Hooper* – The Directors Council; AstraZeneca; PPG Industries; UnitedHealth Group; Warner Music Group
Commissioners
James T. Brady – Ballantrae International, Ltd.; Constellation Energy; McCormick & Co.; T. Rowe Price Group
Richard Chambers – Institute of Internal Auditors
J. Michael Cook – Comcast; International Flavors & Fragrances
Cynthia Fornelli – Center for Audit Quality
The Honorable Barbara Franklin* – Barbara Franklin Enterprises; Aetna; American Funds; Dow Chemical
Patrick Lee – KPMG Audit Committee Institute
James P. Liddy – KPMG LLP
Kenneth Daly – NACD
Peter Gleason – NACD
(*NACD Board Member)
Copies of the complete 2010 Report of the Blue Ribbon Commission on the Audit Committee may be purchased at NACDonline.org. NACD members receive a substantial discount.