In 2003, the SEC adopted rules implementing section 407 of the Sarbanes-Oxley Act of 2002 (SOX), requiring a public company to disclose whether at least one audit committee financial expert (ACFE) serves on its audit committee or to disclose the reason for not having such an expert. Under SEC rules, an ACFE is defined as an individual possessing all of the following attributes:
- An understanding of GAAP and financial statements;
- The ability to assess the general application of GAAP to accounting for estimates, accruals, and reserves;
- Experience preparing, auditing, analyzing, or evaluating financial statements of a breadth and level of accounting complexity generally comparable to that expected to be present in the company’s financial statements (or experience actively supervising others engaged in such activities);
- An understanding of internal control over financial reporting; and
- An understanding of audit committee functions.
To qualify, an individual must have gained the foregoing attributes through any of the following means:
- Education and experience 1) in a position as a principal financial or accounting officer, controller, public accountant, or auditor, or 2) in a position involving similar functions;
- Experience in actively supervising a principal financial or accounting officer, controller, public accountant, or auditor (or an individual performing similar functions);
- Experience in overseeing or assessing companies or public accountants in the preparation, auditing, or evaluation of financial statements; or
- Other relevant experience.
The listing standards of neither the New York Stock Exchange (NYSE) nor Nasdaq require an ACFE per se. The NYSE does, however, require at least one member of the audit committee to have “accounting or related financial management expertise,” as interpreted and evaluated by the board of directors, and Nasdaq requires one member to be “financially sophisticated.” Such sophistication may have been obtained through employment experience in finance or accounting; professional certification in accounting; or any comparable experience, including current or past employment as a CEO, CFO, or other senior officer with responsibility for financial oversight. An audit committee member meeting the SEC’s qualifications is automatically considered to have met the requirements of the NYSE or Nasdaq.
The final rules adopted by the SEC represent a watereddown version of the proposed rules. As originally proposed, an ACFE would have needed actual experience in preparing or auditing financial statements of public companies to qualify, rather than, as the final rules permit, experience either in preparing or auditing financial statements or in actively supervising others engaged in such activities. Thus, in a sense, as proposed, an ACFE would also need to have been an “accounting expert.” Under the final rules, a CEO who “actively supervised” individuals who prepared financial statements could qualify as an ACFE (assuming, of course, all other attributes were satisfied). Because of concerns that very few directors would meet that narrow definition, and therefore that otherwise competent and knowledgeable directors would be excluded, the SEC ultimately expanded the definition to include directors with experience as a CEO.
Not All ACFEs Are Created Equal
While each situation is fact-dependent, it seems clear that someone with only CEO-type supervisory experience over the accounting function probably would not possess—and would not be expected to possess—the same level of knowledge and understanding of accounting theory and practice as someone who has actually prepared or audited financial statements. Whether that difference really matters requires consideration by a company’s board of directors at large and will depend in part on the nature and complexity of the issuer’s business and transactions. For example, the specialized nature of companies operating in the insurance, energy, or banking industries is likely to lead the board of directors to conclude that an ACFE with firsthand industry experience with complex technical accounting issues would be more valuable than an ACFE with only general supervisory experience. Many public companies—not only those in regulated industries—might also benefit from an ACFE with hands-on experience in preparing or auditing financial statements. Recent accounting standards related to revenue recognition, fair value measurement, and derivatives and hedging have become more complex, in part to catch up with the growing sophistication and intricacies of transactions. Thus, a working knowledge of their requirements calls for much more than only a general understanding.
Many observers of the corporate governance process, as well as many audit committee chairpersons, hold the view that ACFEs should be experienced in performing financial accounting functions, rather than simply having supervisory experience. Dennis Beresford, a former FASB chairman, former Ernst & Young national audit partner, and current member of the boards of directors of various public companies, echoes those sentiments. Beresford believes that the criteria for qualifying as an ACFE do not provide for sufficient understanding of accounting and auditing matters. He is particularly concerned that the rules allow former CEOs and others who have supervised finance functions but have not actually performed them to qualify as ACFEs. Though Beresford acknowledges that some of these individuals are outstanding audit committee members, he believes that others simply do not understand the nuances of accounting and auditing matters, internal controls, and SEC regulations to be fully effective audit committee members, let alone experts (Lawrence J. Trautman, “Who Qualifies as an Audit Committee Financial Expert under SEC Regulations and NYSE Rules,” DePaul Business and Commercial Law Journal, Winter 2013, http://bit.ly/1SMMcE3).
Are We Asking Too Much of ACFEs?
The audit committee’s overall role is that of oversight. Two of its main functions are to help the full board fulfill its responsibility to oversee 1) management’s conduct of the company’s financial reporting process (including management’s development of internal control over financial reporting) and 2) the integrity of the company’s financial statements. Even if it were feasible for every audit committee to have an ACFE who possesses a breadth and depth of accounting knowledge gained through experience in preparing financial statements, rather than merely supervising or directing their preparation—which it is not—would that be necessary, or even desirable?
The audit committee, as with the board of directors in its entirety, is charged with oversight and monitoring; such activities do not, in this author’s opinion, rise to a level that requires members of the full board or the audit committee to be experts.
Too Many Experts Could Spoil the Broth
Regarding the preparation of an entity’s financial statements, it could be argued that the CFO and the chief accounting officer (if there is one) are, or should be, experts in GAAP generally, and specifically as it applies to the company’s industry. As for auditors, it could be argued that the entity’s firm of independent accountants is, or should be, experts in GAAP, GAAS, internal controls, and SEC regulations. Therefore, it does not seem necessary for any member of the audit committee to also qualify as an expert. Of course, all audit committee members should be financially literate (as required by the NYSE) or be able to read and understand a set of financial statements (as required by Nasdaq). And it goes without saying that all audit committee members must stay up-to-date on the latest accounting and financial reporting developments. In that regard, there has been at least one recent suggestion proposing that the SEC initiate and administer a CPE-driven certification program for ACFEs (Jonathan Grenier, Brian Ballou, and Seth Philip, “Enhancing Perceived and Actual Audit Committee Effectiveness through Financial Expert Certification,” Current Issues in Auditing, August 2012, http://bit.ly/1TyuPah).
But, in this author’s view, too much emphasis is being placed on the perceived value of an ACFE whose credentials mirror, or even exceed, those of the individuals the audit committee is charged with overseeing. Conversely, not enough credit is given to the value of having a seasoned former CEO or other retired senior executive officer as a member of the audit committee and the ACFE. In addition to the formidable credentials to qualify as an ACFE under SEC rules, such individuals often display a healthy dose of the skepticism necessary for an ACFE and thus are less likely to be intimidated in the boardroom. Plus, such individuals can offer invaluable business and strategic advice based on experience obtained at the highest operating and executive levels.
Finally, even regarding the most complex financial reporting transactions, the best indication that a company’s senior accounting personnel and auditors (i.e., the real experts) truly understand such transactions may be that they are able to explain the essence of those transactions in simple, direct, and lucid terms to ACFEs and others who lack the same level of knowledge.