Audit Committees:
The Hard Questions
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By Edward D. Hess,
Distinguished Executive in Residence and
Adjunct Professor of Management, Goizueta Graduate School of Business
Emory University
Atlanta, Georgia
edward_hess@bus.emory.edu
Audit committees have a significant role to play in our capitalist system as a check and balance on senior management's financial self-interest in aggressively reporting financial results and in meeting the unrealistic assumption of Wall Street that companies should grow smoothly every quarter.
This commentary is based on three assumptions:
1) GAAP provides management with significant leeway in reporting results through various estimates, judgments, and assumptions;
2) Aggressive earnings management can occur and arguably have a colorable claim of legitimacy under GAAP; and
3) It is practically difficult for the CFO and other senior financial management to be an effective check and balance on an aggressive CEO.
It is the Audit Committee's responsibility to be that check and balance on a CEO's aggressiveness. The Audit Committee should, therefore, institutionalize a process whereby at a minimum, on a quarterly and annual basis, it reviews and approves:
1) All accounting adjustments, valuations, estimates, changes in accounting policies or business practices which impacted earnings including income recognition, expense reporting, capitalization policies, reserves, reserve reversals, accounts receivable, bad debt and inventory valuations and reserves, etc.;
2) All related party transactions, all financial engineering, tax products, and M&A transactions which impacted earnings; and
3) All items which the independent CPA firm questioned or had concerns about.
It is time to confront the leeway that management has under GAAP. It is time to illuminate to the investing public earnings management. It is time for Audit Committees to ask the hard questions:
1) Are we complying with the spirit of the rules as well as the form?
2) Are we playing financial games?
3) Where and why are we being aggressive?
4) Is compliance with GAAP our standard of business conduct or should our standard be higher?
This process must include a thorough review with and signoff by each of the following players: the independent CPA firm; the CFO; the Controller; and the Head of Internal Audit. Each should be asked the following questions:
1) Where are we being aggressive?
2) Where are you uncomfortable?
3) What would you change in the financials?
4) What are our financial risks?
5) What are our business risks?
6) Do you have knowledge of or have you heard of or do you suspect accounting or financial shenanigans? If so, where?
7) Are there changes in business practices, accounting policies, or suspect transactions which impacted our earnings?
8) Have we recorded suspect revenue?
9) Have we deferred or capitalized reportable expenses?
10) Are we underestimating, hiding, or minimizing liabilities, or financial exposures?
11) Have we back-dated documents?
12) Are there swap transactions with customers, or suppliers?
13) Are there side or oral agreements with any customer, supplier, or financier?
14) What bothered the auditors but was deemed to be non-material?
15) Where can our controls be improved?
16) Have we recorded revenue prematurely?
17) Have we shipped goods early? Have we billed and then held onto goods?
18) Have we extended the quarterly closing?
19) Do any customers have a right to return goods, and are they likely to do so?
20) Have we extended favorable financing terms to non-credit worthy customers to increase sales?
21) Have we recorded sales that lack substance or are subject to oral or written side agreements, arrangements, or understandings?
22) Have we recorded any investment asset sales or income as sales revenue?
23) Have we recognized as revenue the gains from over-funded pension plans or reduced pension expenses? Have we recorded revenue gains from changing pension plan assumptions?
24) Have we offset operating expenses by investment gains?
25) Have we created income by changing assumptions or estimates regarding bad debt reserves, inventory, or deferred tax revenues?
26) What changes in accounting procedures, practices, assumptions, or valuations have been made with respect to any reserve creation or reversal?
27) Have we capitalized debatable normal operating costs?
28) Have we changed any depreciation or amortization period?
29) Have we failed to write down any impaired asset?
30) Have we made adjustments to the prior quarter? If so, what and why?
31) How do we compare with our peers and competitors with respect to accounting policies?
32) With respect to our accounting policies, on a scale of 1-10 with 10 being most aggressive, where would you rank us?
The institutionalization of a monitoring and approval process which involves separate meetings with the various management participants and the CPA firm is necessary for the Audit Committee to fulfill its management oversight duties. Audit Committees now must select, manage, and control the outside CPA firm. Additionally, the Audit Committee has to assert its authority over the internal financial management to structurally align their interests with the Audit Committee and the duties of fair and full disclosure.
Two further key points: First, the Audit Committee should consider that the CFO, the Controller, and the Head of Internal Audit report both to the Audit Committee and to the CEO and COO. The Audit Committee should structurally align the senior financial management's monetary incentives with their fiduciary duties to shareholders and to the Audit Committee. Dual reporting should give them political security and protection to ensure job performance. Secondly, the Audit Committee should develop one-on-one direct relationships with the CFO, Controller, and Head of Internal Audit, individually, in order to get to know them, their values, and their ethics so as to be a resource and support for them.
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Copyright © 2002
