A report on research into the effect of audit committees in the March 2018 CPA Journal (April Klein, “Questioning the Effectiveness of Independent Audit Committees: Does the Current Regulatory Regime Improve Reporting Quality?” http://bit.ly/2LFI6mg) describes measuring various market and other effects of the audit committee and finding none:
The research measured benefits in two distinct ways: stock market reactions surrounding the process leading to the adoption of a prior regulation requiring companies to maintain independent audit committees, and examination of changes in earnings manipulations and the number of egregious accounting restatements before and after the new requirement became effective. The findings throughout were consistent: there is no evidence that requiring companies to maintain independent audit committees benefits shareholders in terms of stock valuation or better financial reporting quality.
So, why do we have audit committees?
How Audit Committees Happened
The use of an audit committee has become an almost absolute requirement among companies. SEC and PCAOB regulations require all public companies to either have an independent audit committee or have the full board act as the audit committee. Most nonprofits have them, including substantially all large ones. Many other regulated enterprises, such as banks, also have them. Thirty years ago, they were fairly rare; now, they have become ubiquitous.
The big growth came after the passage of the Sarbanes-Oxley Act of 2002, which required all public companies to either establish an audit committee or have the board of directors act as a committee of the whole. By then, audit committees were common to larger public companies, but not universal. Nonprofits had a significant growth of committees at about the same time, along with large private companies and many regulated enterprises.
The creation of the committees was intended to improve financial reporting and reduce financial statement fraud. The benefits suggested were 1) having the auditors report to the board rather than management in order to make them more independent, 2) giving the auditors somewhere to go to express their problems or issues, and 3) having board-level involvement with the audit and financial statement process.
The interesting issue is that there was, and is, no objective evidence that audit committees, in fact, improve financial reporting or reduce financial statement fraud. There was testimony as to the need for more board independence, but no specific identification of an instance where audit committees had eliminated a problem.
Arthur Andersen LLP was brought down, in part, by Enron, which had an audit committee that did not prevent the fraud. I have seen other companies with audit committees act equally badly. The question therefore is, why have an audit committee? Why not just have the auditors report to the full board? Where matters are routine, the audit committee is unnecessary; where matters are significant and substantive, the full board’s involvement is required.
The State of Audit Committee Meetings
I have been to a great many audit committee meetings. I have served on the audit committees of public companies, a nonpublic bank, and a nonprofit, and I have attended many as the auditor for public and nonpublic companies. In general, they are very boring. The following communications to the audit committee occur for all audits:
- The audit plan before the audit is explained, frequently to uninterested or unknowledgeable ears.
- All of the auditors tell you that they are independent.
- There is almost never a change in accounting, except as required by U.S. GAAP.
- I have yet to hear of an instance where management has consulted with other accountants.
- The auditors work hard to have something to discuss with the committee—an alternative accounting treatment, a controversial item, a disagreement with management. The items are rarely significant. If they are, the full board is usually informed much earlier.
- All of the auditors have read the SEC filing and state that they have found no information in the filings that contradicts the financial statements.
The audit committees are always informed of qualitative items, “critical” estimates, and recent accounting pronouncements. Since all of these are already in the Form 10-K, I am not sure why they have to be restated to the audit committee.
I find that the auditors all are anxious to say that the financial statements follow U.S. GAAP, the SEC, or other rules, and that they have performed their audit in accordance with professional standards. Since the audit report says exactly the same thing, why is it necessary to have a meeting to say it?
There is, of course, the required meeting of the board without management. In my experience, auditors do not say anything to the board that they have not said to management. (Disclosure: in my role as audit partner, I have always told management that I can say whatever I want to the board of directors, but that I will always tell them first so they can refute it or at least not be blindsided.) An auditor who has a comment to make to the board that was not previously shared with management has failed the responsibility to communicate issues with management. These meetings are a waste of time.
All of these meetings would be fine if they were not costly. But there are at least two annual meetings required: a planning meeting and an end-of-audit meeting. There may also be meetings with the internal audit staff. For public companies, there are also three quarterly meetings to approve the Form 10-Q. At these meetings, there are at minimum three members of the audit team present, at an hourly cost of (for example) $300, and on average four members of the committee, at probably the same cost. The meetings, with greeting time, take approximately an hour, plus travel time for everyone, which comes to a minimum of six hours per year. Most members of the audit committee receive additional fees for their committee work. Plus there is preparation time for management, the auditors, and the committee, of course, as well as minutes writing afterward. In my experience, it costs a company a minimum of $10,000 per year for one meeting that bores all involved and accomplishes nothing. Larger companies, of course, have much higher costs.
Where matters are routine, the audit committee is unnecessary; where matters are significant and substantive, the full board’s involvement is required.
I believe, as I have written previously with Miriam E. Katowitz (“Have Audits Become Too Inefficient and Expensive?” The CPA Journal, February 2016, http://bit.ly/2A3cmCR) that the cost of audits has become excessive, and we need to address ways of reducing both our time on the audits and nonproductive management time.
I believe that we should eliminate audit committees and audit committee meetings. Because U.S. GAAP, the SEC, and the PCAOB require all the disclosures indicated above, almost all firms include these disclosures in written documents that are distributed to the committee members. The face-to-face meetings add nothing of substance that is not already in these documents.
There are times when the auditors have significant matters to report; for example, a restatement of previously issued financial statements, the inclusion of a going concern modification to the audit report, or a material disagreement with management. In my experience, in each of these cases, we spoke to the full board of directors, as opposed to just the audit committee.
My suggestion is that the audit committee be eliminated, or at least not meet separately with the auditors. The committee or the full board can receive the written audit document with all of the required disclosures. Such a report should be modified to include telephone numbers and e-mail addresses of the partner and the consulting partner on the engagement. If the committee requests it, it can call a meeting. This would represent one way to reduce the cost of audits.
Klein’s article may open the door to changes like this. More research is needed on the topics of both audit committees and the various areas in which auditors have adopted procedures without having any objective evidence that they make financial statements more reliable. I thank Klein for taking this first step.