On December 30, 2019 the Securities and Exchange Commission (SEC) issued a statement on the role of audit committees in financial reporting. This statement follows by a few weeks a similarly focused report from the Public Company Accounting Oversight Board (PCAOB). Together, the two releases underline the importance these regulators place on a well-informed, engaged, objective and effectively functioning audit committee and offer observations and reminders on a number of potential areas of focus for committee members to consider.
Here’s a quick summary:
Tone at the Top – Audit committees need to make it clear to both management and the auditors that the committee wants to be looped in on any reporting and control issues as they arise. It is also important for audit committees to independently engage with auditors and ask questions to help them understand the audit strategy as well as any issues that arise and how they have been or will be resolved.
Independence – Sarbanes-Oxley makes it the audit committee’s responsibility to monitor consulting relationships to ensure that any firm retained to perform an outside audit does not have any business relationships with the company that might interfere with the auditor’s objectivity and independence. Specifically, the audit committee needs to monitor and ensure the adequacy of controls in place to identify and address potential conflicts, with emphasis on avoiding such conflicts in the first place.
Generally Accepted Accounting Principles (GAAP) – Given the significant and complex changes associated with new standards (revenue recognition, leases, and CECL) audit committees need to be working with auditors and management to understand whether implementation plans include adequate controls and deliver adequate and well-reasoned accounting policies.
Internal Control Over Financial Reporting (ICFR) – Audit committees are responsible for reviewing management’s assessment of ICFR effectiveness and the auditor’s attestation, and, if necessary, make remediation a high priority.
Auditor Communications – The SEC expects a robust dialogue between auditors and audit committees, especially on questions related to accounting policies and practices, estimates and significant unusual transactions. This is a critical part of the audit committee’s function.
Non-GAAP Measures – Common adjusted earnings measures, such as Earnings Before Interest and Taxes, Depreciation and Amortization (EBITDA), provide useful information to investors. Audit committees should understand how management prepares and presents this information to ensure that it is consistently prepared and presented from period to period and complies with all applicable financial disclosure controls including reconciling to the most relevant GAAP disclosure measure, as one example.
Critical Audit Matters (CAMs) – Beginning in 2019, certain public companies’ auditors are required to report CAMs (see Protiviti Flash Report) identified during an audit. CAMs should be a part of the ongoing auditor/audit committee dialogue, and audit committees should understand both the reasons for each CAM and how it will be described in the auditor’s report. Once the first-time-through implementation is completed, the committee should understand the nature of each CAM to ascertain with both management and the auditor whether improvements to accounting policies and practices are in order.
LIBOR Transition – The expected discontinuation of the London Interbank Offered Rate (LIBOR) as a global interest rate benchmark in 2021 has the potential to create uncertainty in financial markets. Audit committees should understand how this transition is expected to affect their company’s financial reporting and any products and contracts based on LIBOR. Based on this understanding, the committee should look to management to outline the company’s plan to transition from LIBOR. Time is of the essence to capture the path forward and a lot of work may be necessary to negotiate and rework products and contracts.
The SEC is offering its views to concur, augment and add weight to the PCAOB’s previous guidance based on discussions with audit committee chairs. As such, the SEC and PCAOB continue to emphasize the importance of audit committees in ensuring quality financial reporting and quality audits.
The initial reaction from seasoned audit committee members may be that there is nothing new in the SEC’s guidance; however, the broader message is that the SEC and PCAOB appear to be highlighting their long-standing view that the audit committee is the final line of defense against deterioration of audit and financial reporting quality and to emphasize the committee’s role in championing these important causes for investor protection.
Viewed in that manner, the SEC’s guidance appears to offer a bit more regulatory “punch” in terms of urgency, particularly as it relates to setting expectations with management and the auditor regarding ongoing communications on a variety of critical financial reporting and audit quality issues.